#9 Russell Napier & Jeremy Hosking – 2 Capital Cyclists

Russell Napier and Jeremy Hosking - BTBS

Russell Napier is one of the foremost macro commentators in the world and has been an adviser on asset allocation to global investment institutions for over 25 years. He is the author of Anatomy of The Bear: Lessons From Wall Street’s Four Great Bottoms and of The Asian Financial Crisis 1995–98: Birth of the Age of Debt. He founded and runs a course called A Practical History of Financial Markets (in person and online), he founded the Library of Mistakes and is a non executive director of more than one quoted company.

Jeremy Hosking is a partner of Hosking Partners and was previously a founding partner of Marathon Asset Management in London. He is a co-author of the cult book Capital Account and its sequel Capital Returns (on whose cover Russell Napier is quoted). Both books explain the Capital Cycle theory, whose origin Jeremy discusses in the podcast.

In this interview we discuss the coming age of financial repression and why the capital cycle theory will be so important for investors in this new era. We also discuss the banks sector, the Asian crisis, value vs growth and the problem with ESG.

SUMMARY

In this fascinating interview, we have a wide ranging interview with Russell Napier and Jeremy Hosking, covering everything from banks to ESG, from Tobin’s Q to excessive liquidity, and from the tragic events in Ukraine to the sinking of the Titanic. One theme is constant, however – the capital cycle, and we discuss in detail its mechanics and the reasons why it’s such an effective investment tool.

INTRODUCTION

I have known Russell for several years – we met in a bar in Hong Kong and continue to have fascinating conversations over a glass. Russell has long been one of the most intellectually advanced thinkers in the stock market and often prefaces his predictions with the caveat that he can be years early. His last major forecast – that he was abandoning his long held view of disinflation and now foresaw an inflationary period ahead – in the summer of 2020 was prescient.

Quite coincidentally, I also met Jeremy in Hong Kong, at an investor presentation by Manchester United. He is a shareholder in Crystal Palace. H enow runs Hosking Partners, a global long-only value firm, having previously been a partner in Marathon Asset Management which produced the books Capital Account and Capital Returns, both authored by Edward Chancellor.

Russell had agreed to do the podcast and as his last quarterly was entitled the Capital Cycle in an Age of Financial Repression, suggested we get Jeremy to join us to give his unique perspective on this topic.

A one hour podcast was never going to be enough to do justice to this multi-faceted subject. Apart from covering why we are entering an era of financial repression, and why the capital cycle becomes even more important, we also tried to explain what financial repression is and to explain the capital cycle.

Many investors have come into the business in the last ten years and it would be easy to assume that an era of falling rates and massive liquidity was normal; that growth stocks would be pushed to excessive valuations, especially in private markets; that companies in the real world would continue to be starved of investment; and that mean reversion was a 20th century phenomenon.

In the podcast we discuss why such a view will produce terrible investment results in the next decade and we touch on why the retreat of globalisation adds another dimension to the capital cycle argument. We recorded the podcast on Thursday, March 10 and Russell and I met David Einhorn on Monday, March 14. His commentary was such a strong reinforcement of our podcast discussion that I recorded a postscript with Russell afterwards.

If you are a growth investor, some of this may make you feel uncomfortable. If you are a value investor, some of this will make you very curious.

GETTING INTO INVESTING

Russell trained as a lawyer and joined Baillie Gifford in order to work in Edinburgh, rather than out of any strong desire to be a fund manager. Jeremy’s first role was with growth manager GT Management and watching the tech collapse in 1983 led him to the capital cycle approach. He and two partners then founded Marathon – he was the oldest at 28

THE ERA OF FINANCIAL REPRESSION

Russell Napier changed his long held disinflationary view when he saw the degree of money printing in the pandemic and now believes inflation is here to stay. He believes that the consequence is that Governments will have to force savers to hold their bonds and prevent some institutions from holding their current levels of equities. Naturally, this will have consequences for equity valuations, and Russell believes that investors will have to focus on value stocks as equity indices may not perform as they have in the past. This is quite radical thinking, but Russell explains his logic in the podcast.

BANKS

Jeremy is invested in banks and believes they could prove very cheap if they are disciplined on capital allocation, although he is not confident that their management are up to the task. Russell, formerly a banks analyst, explains that the old 3-6-3 regime (pay 3% interest on deposits, lend money out at 6%, and be on the golf course at 3pm) may come back into vogue – in an era where credit is rationed, “you will have lent all your money by 2.30pm”.

REPLACEMENT VALUE OF ASSETS

We discuss Tobin’s Q and why some understanding of this variable is particularly important when investing using a capital cycle framework. Like all valuation parameters today, this variable stands near a high (and if it falls to its historical bear market bottom of 0.3x, we could be in for some trouble). Jeremy discusses why accounting is sometimes unhelpful and Russell explains that the Q tracks the CAPE ratio, in spite of increasing emphasis on intangibles.

russell-napier
Jeremy-Hosking

BOOK RECOMMENDATION

Jeremy recommends

The Tao Jones Averages: A Guide to Whole-Brained Investing by Bennett Goodspeed. Neither Russell nor I had even heard of this book which is still available on Kindle. The blurb reads ”Although influenced by logical factors, changes in the market are often irrational and illogical. This savvy and amusing little book demonstrates how- with the help of both the left (logical) and the right (intuitive) hemispheres of your brain- you can anticipate market fluctuations and achieve a greater financial return”.

Russell recommends

The classic Adam Smith’s The Money Game, a particular favourite of Steve’s who has read the book 3 or 4 times and Chapter 12 several more. Russell also suggests Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh and Mike Staunton priced at £101 on Amazon UK and $140 on Amazon.com.



HOW STEVE KNOWS THE GUESTS

Steve met Russell in a bar at the CLSA conference in Hong Kong and Russell has been instrumental in the setting up of Steve’s training business, by introducing him to Stewart Investors in Edinburgh, for whom the original Forensic Accounting Course was designed. Thanks Russell!

Steve has known James Seddon, Jeremy’s partner at Hosking Partners and prior to that at Marathon Asset Management for many years, and James introduced Steve and Jeremy. Russell and Jeremy are old friends so this made for a fun collaboration.

THE LIBRARY OF MISTAKES

Russell is quiet about his extensive charitable activities but one which is well-known and deserves a wider audience is the Library of Mistakes. It is moving to new premises and will be officially opened by Lord Darling the week after the podcast airs. I visited its original site and it is just full of fascinating material on all aspects of investing, but I particularly enjoyed the materials on past frauds. If you are in Edinburgh, it’s a must visit.

library+of+mistakes

HOSKING PARTNERS

Jeremy’s firm publishes an interesting blog and its strategy is explained on its own website and in this interview with James Seddon. Some of its top US holdings are listed in the table. There is an interesting mix of value and growth and banks are well represented. Note Costo, Berkshire and Delta Airlines. Total US holdings are reported to be $4bn, the company does not disclose its total AUM.

holdings

Source: Whale Wisdom, as of 12/21

RUSSELL’S WORK

If you want to learn more about Russell’s work, you can

  • sign up for his newsletter here

  • enrol in the online version of his course, The History of Financial Markets, here

  • enrol in the in-person History of Finanical Markets course here

  • buy his first book, Anatomy of the Bear, on Amazon UK or Amazon.com

  • buy his second book, The Asian Financial Crisis 1995–98, on Amazon UK or Amazon.com

THE MARATHON ASSET MANAGEMENT BOOKS

The original book, Capital Account, is now out of print, but Capital Returns is still available – Amazon UK or Amazon.com.

These are Amazon affiliate links and we donate the money raised to charity. Fill your baskets!

Chapters

00:02 – Introduction and Investment Background
09:58 – Government Intervention and Inflation
17:55 – Equity Market and Value Investing
25:45 – Banking History and Valuations
37:26 – Fundamentals and Tech Stocks
45:58 – Accounting Challenges and Market Performance
53:55 – Rotation from Growth to Value
01:08:09 – Capital Cycle and Financial Repression
01:17:28 – Future Outlook and Concluding Remarks

TRANSCRIPT

An AI generated transcript which only has had very slight editing

STEPHEN CLAPHAM: Hi, welcome to the Behind the Balance Sheet podcast where we meet leading investors and commentators and educate ourselves about the world of investing and the world. Our mission is to remove some of the mystique around investing and improve our understanding of what makes a successful investment or indeed an unsuccessful one. Our goal is to inform, educate and entertain.

We hope you enjoy this and every episode behind the balance sheet and affiliates and podcast guests may own shares or have an economic interest in securities discussed in this podcast which is aired for your education and entertainment only nothing in this podcast should be construed as investment advice or relied upon for investment decisions. Always do your own research.

STEPHEN CLAPHAM: This podcast is intended to educate as well as entertain and it has a more serious purpose. We are big supporters of the Financial Times financial literacy and inclusion campaign, a new charity which you can check out on F T dot com forward slash F L IC.

STEPHEN CLAPHAM: It’s the most disadvantaged in society who often get taken in by financial scams by payday loans and similar artful devices to park people with their money.

STEPHEN CLAPHAM: We can change this. It’s a straightforward task of education.

STEPHEN CLAPHAM: This really is a great cause and I urge you pleased to support it. The podcast is sponsored by Sentieo and I asked them because I use the research platform almost every day for equity analysts. It’s in many respects the ideal tool. If I didn’t have a professional platform, I would need several different software systems. Sentieo saves me a lot of time and ensures my research can be done in one place.

STEPHEN CLAPHAM: I like it because first, the data is reliable and it aggregates all content. Second, it’s easy to use and much more intuitive than some other platforms. Third is features I have never seen in other systems. My favorite is the ability to go into a 10-K and extract the history for a particular data table if I want to see the trend in a parameter.

STEPHEN CLAPHAM: And I often do this, I snap my fingers without having to dig through multiple 10-K S. It’s much faster and easier, but most important, it’s the price, there’s a huge price advantage over other systems. If you’re a smaller fund or even a larger fund equipping analysts, Sentieo is definitely worth looking at visit cent O dot com forward slash BT BS for behind the balance sheet. For more details.

STEPHEN CLAPHAM: When I asked financial historian and author Russell Napier, if you would be a guest in our Macro mini series, he suggested that we cover the capital cycle in an age of financial repression, which was the subject of his last quarterly for his institutional clients.

STEPHEN CLAPHAM: And he suggested that we invite Jeremy Hoskin, the former partner of Marathon Asset Management and coauthor of the book Capital Account, which introduced the concept of the capital cycle to the investment world.

STEPHEN CLAPHAM: After some gentle persuasion, Jeremy agreed and we had a really interesting discussion which I hope you’ll enjoy before I let you listen to that. However, I think a few words of explanation will be helpful as we cover a lot of ground. And the subject itself is quite complicated. Of course, the capital cycle concept is now well known.

STEPHEN CLAPHAM: You should pay more attention to supply than traditional investors who tend to focus on demand and you should buy into industries where capacity is exiting. But as we explore here, the capital cycle can be viewed on multiple levels and in a more subtle fashion.

STEPHEN CLAPHAM: If you think about it for the last 10 plus years since the global financial crisis, the global monetary system has favored growth stocks. We’ve had abundant cheap and falling rate, financial capital and it’s flooded markets that has favored growth stocks and the supply of capital to traditional industries has been restricted.

STEPHEN CLAPHAM: The recent E S G ball has further starved industries like energy and commodities of investment, which makes them much more interesting today.

STEPHEN CLAPHAM: But we’re now moving to a world of financial repression and higher inflation which will be less favorable to equity indices, value stocks are likely to come back into vogue as will stocks with inflation protection, highly valued growth stocks are likely to fare less well in this environment. Further complicating the issue is a trend to de globalization.

STEPHEN CLAPHAM: A new trend which is likely to be an ongoing feature going forward which will require more capital to go through traditional industries at a time when that capital is less abundant. I hope this helps to set the scene for our discussion. And I added a post script with Russell at the end, just round the subject off.

STEPHEN CLAPHAM: So please do listen to that right at the end. I hope you enjoy this and it’s a subject which I inevitably am gonna come back to both in the podcast and in my new newsletter on subs.

STEPHEN CLAPHAM: So check out the related letter that I’ve sent to my subscribers, which you can find on my website or on substack under behind the balance sheet. And please let me know what you think about all this and I will share your comments with Russell and Jeremy. Thanks for listening. I hope you enjoy the podcast.

STEPHEN CLAPHAM: Russell, Jeremy. welcome to the podcast. I’m really pleased to have you here. And as usual, I would like to ask you both how you got into investment management. Russell, your dad was a butcher. I guess he didn’t have aspirations that you should become a financial historian and you actually studied and trained to be a lawyer. I think. How did you get into investing?

RUSSELL NAPIER: Well, my father had aspirations and I could be anything except a butcher. This was his aspiration. So it you start jumping hurdles and you never know when you end up. So I wanted to do one work in Edinburgh. So I fell in love with the city of Edinburgh. Having spent six years getting qualified in English law. So that was a bit of a, not a very bright thing to do.

RUSSELL NAPIER: So, the only people who would give me a job and I mean, the only people who offered me a job anywhere in the United Kingdom were a tiny little investment boutique called Bailey Gifford. So I took the job because it paid quite well. I haven’t the faintest idea what fund management was, but I got to live in Edinburgh. So Chance is the answer, Steve. It’s funny.

STEPHEN CLAPHAM: There’s many of the people in the podcast that that’s been their story. How about you, Jeremy? Did you, was it Chance or did you always want to be a successful investor?

JEREMY HOSKING: Well, it was chance and a form of nepotism because I was having a family lunch with friends. And the host was a giant in the city of London. And he turned to me and I asked what, what I, what I had in mind for my life. And I said it was 1975. I said, I, I’m a monetarist and he said, when can you start?

JEREMY HOSKING: And who’s that? A fellow called Richard Thornton. And the company was GT Management.

STEPHEN CLAPHAM: A remarkable company that was so Roger Yates and train.

RUSSELL NAPIER: So you overlap with them or, and a few more whose names are gone on to be legion in the City of London? So, do you, do you still keep in touch with Nick because you’ve got very opposite, very different, not opposite, different offices.

JEREMY HOSKING: So we didn’t, we didn’t speak to him, but we were, we were officially and unofficially on the same team. All right.

STEPHEN CLAPHAM: Ok.

STEPHEN CLAPHAM: And you you got together to launch Marathon in 1986.

JEREMY HOSKING: Was it the end of 1986? Yes.

STEPHEN CLAPHAM: So you must have been quite young then.

JEREMY HOSKING: Well, relatively, I suppose. That’s right. I mean, all the three founders of Marathon, I think I was 28 I was the oldest.

STEPHEN CLAPHAM: So how did you have the confidence to set up your own business at that, that point is that have been quite unusual back then in the eighties?

JEREMY HOSKING: You know, we had a, we were working, we were two of the three founders were working at this company called G T Management and G T Management was officially a growth style investor with a bias towards technology.

JEREMY HOSKING: And in 1983 the first of a long line of technology busts came along and these I think there was something like this is mentioned in Capital Account, there was something like 200 disk drive companies in America.

JEREMY HOSKING: So of course, various technology sectors went into freefall because of the excessive competition. And I and some of my colleagues were arguing for a more value oriented approach and that eventually gave rise to the thinking behind the capital cycle as an investment approach.

STEPHEN CLAPHAM: Well, we definitely will come back to Capital Account and the idea of the capital cycle. But before we, we do that, let’s just paint the Macro picture because inflation. So we’re recording this and on the day that us, inflation has hit 7.9% which is a long time since it was last there.

STEPHEN CLAPHAM: Russell, you’ve said that you see inflation over the next few years being at 4% and spikes above that. I mean, have the recent tragic events in Ukraine altered your view or is that or is that the floor now? What, what’s the, what’s your prognosis?

RUSSELL NAPIER: Well, they make inflation more likely because inflation is everywhere at all times a monetary phenomenon. So the question for me is not, is the oil price up, is the oil price down? It is, does this legitimize the creation of even more money?

RUSSELL NAPIER: And the pandemic has already done that so that the monetary revolution that occurred in March May to May 2020 was that governments issued credit guarantees to banks and banks. Then for the first time in their history issued huge amounts of loans into a recession and a lot of money was created in a recession, which is still out there. Obviously, it hasn’t gone away.

RUSSELL NAPIER: And I’ve been told over and over and over again by knowledgeable people that this was a one off emergency measure to offer these things. And then just a few weeks ago, the government of the United Kingdom offered a similar guarantee to Jaguar Land Rover. The banks lent 600 million to Jaguar Land Rover. Not all of that but a large proportion that was guaranteed by the government.

RUSSELL NAPIER: And now the banks are making another loan guaranteed by the government. And obviously everybody knows who’s listening to this. When the fractional reserve banking system makes loans, it creates money. And then we had an emergency in the energy crisis once again before the war.

RUSSELL NAPIER: And the government said to the banks, you will lend money to the energy companies and this will permit the energy companies not to pass on in full the price of enemy to its energy to its customers. So once again, money is created so that the British government has decided that the best way to attack inflation is through printing money.

RUSSELL NAPIER: Now, warfare has the same effect. We will I can guarantee you that before the year is out, there will be large loans going to defense contractors. I did notice that we’re now backing shipbuilding as of yesterday. According to the British government, it’ll be interesting to see if that’s funded by bank loans.

RUSSELL NAPIER: So, Steve, as long as the government is involved in forcing cajoling, forcing, I prefer forcing, I call it capitalism, forcing the banks to make loans. They are making money and will have inflation and the oil price can go up and down.

RUSSELL NAPIER: But against that background of much higher levels of growth in the money supply, that is where I come up with the answer to inflation and all of it is so much easier to justify in a period of a national security emergency. But it is worth remembering before the national security emergency, we had an inequality emergency, a climate emergency, a health emergency and now a national security emergency.

RUSSELL NAPIER: And there are so many emergencies about that. It’d be difficult to see how we’re not going to get it so called emergency finance and emergency finance means more money and it means more inflation.

STEPHEN CLAPHAM: I should just point out that when you’re talking about loans to energy companies, you’re talking about the UK electricity sector primarily for those because this podcast is listened to by people in 100 countries. Would you believe? I find that hard to believe, but that’s what Spotify tells me.

RUSSELL NAPIER: There may be people who’ve never heard of Boris Johnson listening to this.

STEPHEN CLAPHAM: No, everybody’s heard of Boris Johnson.

STEPHEN CLAPHAM: Jeremy. So do you agree with that view? I mean, you can remember inflation.

JEREMY HOSKING: Yes, Yes. And I do agree with that view. It’s been my view really since the aftermath of the global financial crisis. And it’s a view that’s been wrong for about 10 of the last 12 years. I think when I think Russell called it beautifully in 2020 didn’t you change your mind on this? Yeah.

JEREMY HOSKING: And said it hasn’t been inflation now, but now things have changed because effectively the central banks are putting money directly into the hands of the, the public and private sector companies. Whereas before they were simply putting it into the banks and the banks had two departments, there was one department taking government money and there was another department controlled by the regulators telling them not to lend it.

JEREMY HOSKING: So the velocity of circulation collapsed. And it’s a, it’s a topic in economics that’s basically received virtually no attention in the last 12 years. Why the Monet model from 2010 to 2020 simply didn’t function. It was, it was, I’m not, I’m not an economist so I can’t help you on that. But I’m struck by the absence of commentary on it.

STEPHEN CLAPHAM: Funny enough when you talk to an economist, they say they’re not an economist. Russell Russell will say he’s a financial historian. Chris Wood says he’s a strategist. He trained as an economist, but he’s a strategist.

RUSSELL NAPIER: Steve. Steve. We have to say this if you know formal qualification in economics and claim to be an economist. The economist union gets desperately upset. Of course.

STEPHEN CLAPHAM: So if we’re going to have inflation and Russell’s call was incredibly well timed, but Russell has taught his clients to expect his prognosis not to happen for several years afterwards. So, you know, this has been amazing how fast this has happened.

STEPHEN CLAPHAM: You must be surprised yourself.

RUSSELL NAPIER: Sure. I mean, what you’re pointing out, Steve is my timing isn’t always immaculate. I plead guilty. I plead guilty to that.

RUSSELL NAPIER: Yes and no, because something really, really important happened very quickly. I mean, these credit bank guarantees happened really in an afternoon for tens of billions and not just in the United Kingdom kind of everywhere. So to me, that was a clear structural change in the system. So finally, maybe I had more Chance of being right on the timing. I wasn’t being critical.

STEPHEN CLAPHAM: I was only reflecting what you’ve publicly said, you said yourself.

STEPHEN CLAPHAM: But if we have got inflation and we haven’t had inflation for years and years, are you changing, Jeremy? Are you changing your investment style? Are you just doing everything the same way?

JEREMY HOSKING: Well, we’ve made, we hold our portfolios are very stable for long periods of time. We hold a great number of shares and the only, I mean, the main theme of what my colleagues and I have been doing in the last three years has been reducing exposure to the digital winners at high prices and buying, buying shares in companies which have bounced back.

JEREMY HOSKING: Potential. Fortunately, one of those sectors has been the natural resource sector. So of course, there are many sectors like hospitality and travel that haven’t bounced back at all, but commodities bounced back rather splendidly.

STEPHEN CLAPHAM: And do you think that’s gonna continue?

JEREMY HOSKING: I haven’t done any selling.

STEPHEN CLAPHAM: Ok. That’s, that tells us, I mean, Russell just following on from inflation. You, you’ve talked about financial repression and in fact, I googled financial repression because I wanted to make sure that I had a proper definition of it. And when you Google financial repression, one of the automatic offers one of the suggestions on Google is financial repression.

STEPHEN CLAPHAM: Russell Napier. So obviously, you have become known as being one of the experts in financial repression. Can you just explain the concept? And can you then just explain how governments are going to be able to keep yields low? I had a conversation this week with an economist who claims to be an economist and Roger Nightingale who thinks that yields are going to go to 8%.

RUSSELL NAPIER: Well, I obviously, I think he’s wrong. He might be wrong in a, in a free market and market determined prices. But I think that’s one of the problems with economists. They seem to assume that we always live in a market, an era of market determined prices.

RUSSELL NAPIER: Jeremy mentioned in 1986 that was Big Bang So, you know, it wasn’t too long before that, that this country lived with non market determined prices, the, financial repression, by the way, I think the term comes from Ronald Mckinnon, which would be in the late sixties.

RUSSELL NAPIER: But it’s, it’s something we’ve been familiar with since at least World War One, artificially depressing bond yields. It comes with lots of other things which I’m sure we’ll get on to. But the mechanism is really relatively straightforward. It’s been underway for some time by central banks.

RUSSELL NAPIER: But as Jeremy mentioned, a lot of the liabilities, the central banks created in purchasing those bonds and keeping yields low sat dormant in the banks partially for one of the reasons that he, that he mentioned. So it didn’t turn out to be that dangerous or as dangerous as many economists thought it might be.

RUSSELL NAPIER: But you can’t do that forever, particularly in a period of high inflation because to be throwing that liquidity onto the fire of inflation is particularly dangerous is actually a road to hyper inflation if you keep doing that. So they’re gonna have to find somebody else to buy all these bonds and keep the yields down and, and somebody who in doing so does not create more money, does not add more liquidity to the fire.

RUSSELL NAPIER: And that is the, the the saver that is who has always done it in the past. If you would go back to Neil Ferguson’s the cash nexus countries that successfully fight wars tend to do it by mobilizing their savings through the assurance of bonds, often at particularly appalling yields and won those who fail, tend to print money.

RUSSELL NAPIER: So we, I’m not saying we won’t do a little bit of printing money as well. That’s the basic tenet of the whole thing, but that’s how we do it. Now, most economists won’t accept that because I say nobody would be stupid enough to give up the market economy. You know, nobody expects the Spanish inquisition. I expect the Spanish inquisition. They’re here red and tooth and claw.

RUSSELL NAPIER: And that’s why I differ from economists. And of course, I’m doing that based entirely upon analysis of the past and the last time, our debt to GDP ratio in aggregate public and private was this high. These are the things we did. So it’s not an outrageous forecast to say these are the things we’ll do again, even though none of them are taught in economic classes or in finance textbooks.

STEPHEN CLAPHAM: And, and what will be the mechanism will be yield curve control.

RUSSELL NAPIER: I mean, you can’t force people to buy bonds, you can force people to buy bonds quite easily. And some of you people listening to this will be in the life insurance sector will be chuckling at that statement because they’ve been forced to buy bonds for years on their asset liability modeling.

RUSSELL NAPIER: So of course, you can do that you can just say that saving is a very dangerous thing. We live in dangerous times and risk free assets must be held in quantity and therefore a certain percentage of a life fund or a defined benefit fund even certainly defined, even as far as a defined contribution fund, must be held in the form of government bonds.

RUSSELL NAPIER: If you think this will be Ivan only to people in the United Kingdom until recently, your pension on maturity had to be forced into an annuity. Well, that was forcing you to buy ultimately government bond and long term debt securities. And that was a legacy from the old system which we only just got rid of just in time for the new system.

RUSSELL NAPIER: So there are many, many ways, but it’s, it’s through the powers of regulation. So forcing you the individual Steve Clapham to buy government bonds is quite tricky and, and as an Englishman or in your case, a Scotsman’s home is his castle.

RUSSELL NAPIER: The interference of property rights to that degree are not really acceptable, but they will willy nilly interfere with the savings that you happen to have in a regulated financial institution that’s, that’s legitimate. It’s been done and it will be done again. And it’s called a global Macro Macro prudential regulation. It kind of rhymes with their scans with motherhood and Apple Buy.

RUSSELL NAPIER: So when you say which, which financial institutions, but I’ve just written a huge report on this for clients. I look through the flow of funds, statistics of the United States Of America to see who’s got a lot of money and it isn’t in bots. So you start for, in the case of America’s private pensions, a state and local government retirement schemes.

RUSSELL NAPIER: And the third one, it will come back to me, but they’re actually quite a large pots of savings with virtually no government bonds and it’s the same in the United Kingdom. So the life insurance companies have been repressed. They do have a lot of government bonds, but even there you can push them further forward.

RUSSELL NAPIER: So there’s plenty of pots of money to be stolen. People always say, oh when you get a situation like that, you get hyper inflation, hyper inflation comes after you’ve stolen all the savings. Not before there’s no point in going to hyper inflation until you have abuse the saving system first. So that’s our first port of call.

STEPHEN CLAPHAM: And these pots of money. Are they in the equity market today?

RUSSELL NAPIER: Yes, they are. I mean, I, I’ve looked that up. So I mean, for, I mean, 40% of most of those funds will be in equities direct. Usually our 2025% is in mutual funds, which is, which themselves are 70% in equities. So if you’re going to force, this is the problem for the equity market.

RUSSELL NAPIER: If you’re going to force these institutions to buy government bonds you’re forcing them to sell equities. And the only equities they can sell are the ones they own and the only ones they own are owns in the index on the whole because they tend to be, whisper it softly.

STEPHEN CLAPHAM: Closet indexers or Germany is not a closet indexer, but this doesn’t sound good for, for anybody investing in equities. Right. I mean, what do you think Russell’s? Right.

JEREMY HOSKING: Well, I, I fully agree with the punters who say the equity market seems overvalued.

JEREMY HOSKING: I think a more dominant theme is though the crowding in big index stocks and a small number of very large technology companies otherwise known as growth stocks.

STEPHEN CLAPHAM: But if you think that equities are, are fully valued or overvalued, I mean, presumably, I mean, are, are you able to hold a lot of cash or would you do, would you do that in, in principle or?

RUSSELL NAPIER: Well, we’re, we’re able to do it, but an alternative strategy is to hold shares that are inexpensive, which tend to be very unpopular when I looked at the last US, repression state, which really only gets going after in their case after the breakdown of the Bretton Woods agreement and the, and the oil shocks, the stock market does very badly in aggregate, the S and P does not beat inflation.

RUSSELL NAPIER: But this is 1966 to 1982. You know, the AND P goes from 1000 to 600 but value stocks do provide a positive real return over that period. And in that period as well, small cap stocks produced a positive real return.

RUSSELL NAPIER: But if you held the index stocks, you lost a lot of money. And of course, if we move forward a little bit from 66 to 72 which is the peak of the infamous 50 50 well, you lost more than a little bit of your money than being in, in overvalued stocks.

RUSSELL NAPIER: So my own view is that despite this compulsory liquidation of some equities, the place to be is equities. Just not the ones that are owned widely by savings institutions who’ll be forced to sell them and every equity is owned by somebody. But in the, in the institutional space, there are definitely under own equities.

STEPHEN CLAPHAM: Well, it’s interesting you bring up the nifty 50 because there’s a lot of parallels with the Fang stocks and then nifty 50 very, very highly valued can do, can do any wrong. And as you say, the value stocks did ok, over that period probably did better than ok if you did it from 72 to 82.

RUSSELL NAPIER: Yeah. Well, I I just happen to measure it from 66 but positive real returns in that environment is pretty spectacular. Given the annual rate of inflation through, through the seventies. And that’s what value stocks managed to produce.

STEPHEN CLAPHAM: Of course, if you’re starting either from 66 or 72 you’re starting off if you’re looking at value stocks, you’re starting off very, very low multiples even. I mean, much lower than they are today.

RUSSELL NAPIER: I think you should ask Jeremy just how cheap the value stocks are or how expensive they are. I mean, he’s the expert.

JEREMY HOSKING: Well, the, the question is multiples of what, what you like.

STEPHEN CLAPHAM: We, we like.

JEREMY HOSKING: Well, the trap, the trap, I’ve fallen into many, many times is buying shares when the pe ratio was low. But it always in almost invariably meant that the E was too high, not that the P was too low. So I think it makes a lot of sense to move into metrics which are more holistic like sales as you mentioned or replacement cost.

STEPHEN CLAPHAM: So replacement cost is, is a good one because that brings us on to the capital cycle and this is, this is super interesting. So obviously you are one of the coauthors. Well, Edward Chancellor is the author of the book. It was a collection of writings from Marathon Capital Account.

STEPHEN CLAPHAM: A book which is currently selling for £400 is out of print. And I think I’m going to, I think I’m going to auction off my copy. And what we should do is we should auction off a copy and donate the proceeds, the library of mistakes. That would be a good thing to do.

STEPHEN CLAPHAM: But that book was brilliant and it was pretty revolutionary at the time. How did you and colleagues sort of come to this conclusion because it was, I mean, today people understand this concept. But when that book came out, which I think was in 2004. So 18 years ago, it was a, it was a really new concept.

JEREMY HOSKING: Well, I think part of it was, and it goes back to the setting up of Marathon in 1986 there were three guys in a room in London.

JEREMY HOSKING: And the consensus at that time, particularly if you are a global or international investor is you need people all over the world gathering information.

JEREMY HOSKING: And one of the things that we were very fortunate about is it coincided with the information era and we could just sit in a basement room in London and information would come to us. The next, the next important decision point was why would we look at earnings because earnings fluctuate a lot.

JEREMY HOSKING: And if there’s a big world out there and you’re three people in a room, you simply cannot look at things that are fluctuating a lot. You have to think you have to look at things that move hardly at all. So you’ve got the time to notice them, especially if they’re in a long, a long way away in Japan or Malaysia or something.

JEREMY HOSKING: So we, and because competition and capital allocation changes relatively slowly, that was some, the supply side became something we could look at. So we had to get even outside the business cycle framework because the business cycle was also fluctuating too fast for us to keep up with it. And that’s where the sort of 12 year turnover period and the long term supply side came from.

JEREMY HOSKING: And there, if you go back to the the famous Boston consulting group quadrants where all companies are allocated into four quadrants, you know, the famous cash cow or stars or, and that led to the insight that you could be anywhere on that matrix providing, the company was being managed in a way that was consistent with the matrix.

JEREMY HOSKING: So you could be in a growth stock that was growing or you could be in a value stock that was shrinking. That would, and we found out quite a early on that a very good place to be was value stocks that were shrinking.

JEREMY HOSKING: And one of the things the banking sector has not done in the last 10 years and should have done has been to shrink their balance sheets aggressively and to say to the regulators who are interfering in their business no enough, we are cutting our loans, we’re gonna, we’re gonna ration credit.

JEREMY HOSKING: So the net interest margins go up even in a low interest rate environment and we’re paying all the dosh out to shareholders because you can’t, we’re not, we refuse to be regulated into an environment where our shares sell at half book value, but they have, which is what is happening, but the, the regulators wouldn’t allow them to do that.

STEPHEN CLAPHAM: Presumably. I mean, and there’s all this money has to find a home somewhere, doesn’t it?

JEREMY HOSKING: I don’t see how they could stop them, but most of the people who manage banks are rather more interested in their knighthoods on retirement than looking after the shareholders interest.

STEPHEN CLAPHAM: Well, Russell, would, the banks be able to do that? I mean, you’re a, you’re effectively a bank analyst, right?

RUSSELL NAPIER: I did actually start as a bank analyst and I think it was one of the best things I ever did to understand a bank. As someone who was a lawyer discovering the banks were commercial operations was a shock. I thought how could any, any, anybody be allowed to run something like this? And then when I discovered that they also made money, I thought this is ridiculous.

RUSSELL NAPIER: But anyway, it, it’s, it’s the history. So I look at the history of banking and Jeremy’s right. But he’s also wrong because obviously they have controlled the bank balance sheets. I mean, at one stage we had a thing called credit controls. And basically, if you were out west, you went along to see the government. He said this year guys, it’ll be, 8% you’ll be making 8% more loans this year.

RUSSELL NAPIER: And here are the things that we kind of think within that 8% you should be doing. And then he would raise his eyebrow. So the question is, are we going back to that or not? And the whole point about Big Bang was to get away from it, that it was over and it was dead and it was gone forever. So obviously my big call is we’re going back to it.

RUSSELL NAPIER: And that loan I mentioned to Jaguar Land Rover, the loan to those those electricity providers tell me that that is back. So the banks are captured, they should trade a half times book because they’re not commercial operations. It is banking with Chinese characteristics and we know that the right valuation for bank with Chinese characteristics is 50% discount to failure.

RUSSELL NAPIER: Now whether they should have fought against it or not, it doesn’t matter. But Jeremy’s right about the their need to get the right level of gongs. And I think that is a, you know, the agents don’t play to the same game the agents are playing to a different game. I think Jeremy very, very eloquently summed up the game the agents were playing to.

JEREMY HOSKING: But the low valuation of Chinese banks probably is due to the periodic occurrence of massive levels of bad debts. Whereas the new loans you’re talking about are loans with a government guarantee. So these are low risk loans.

RUSSELL NAPIER: Yeah, I find myself very conflicted with banks. I can see how the the earnings are going to surprise on the upside. I can see how credit risk is going to be lower than expected. But at the same time, I can see that this is a product of government interference. So, structurally that suggests to me it’s not the place to be, but cyclically, probably.

RUSSELL NAPIER: So, I mean, I don’t usually have a problem having a black and white answer to just about anything in life. Never mind. Finance. I think it’s cultural. But, the banks I think are quite tricky because their earnings could surprise on the upside. And as you point out, they’re now making loans to anybody.

RUSSELL NAPIER: They want effectively risk free, not quite anybody they want, but all the COVID loans, the land rover loans, the energy loans and who knows what else the government has got up its sleeve that they can lend to risk free. But what? But to your point doesn’t that mean they’re more captured but they not good.

STEPHEN CLAPHAM: I mean, it’s like a regulated utility except they don’t have customer complaints.

JEREMY HOSKING: They do have customer complaints.

JEREMY HOSKING: I do my best.

RUSSELL NAPIER: I have customer complaints from the liability side. I think whether they have any, I don’t think they have any complaints from the asset side given the price of being forced to lend that. But us on the liability side will do our very best to keep complaining to the banks.

STEPHEN CLAPHAM: But I mean, it’s a perfect regulated utility, isn’t it? You don’t have the issues of the commodity price or, or customers are going to repay their loans or the government will repay their loans. What the picture Russell’s painting at half book value sounds like fantastic to me.

RUSSELL NAPIER: I, I find myself in a problem. I’m I’m recommending to my clients that they invest in companies that are reducing reasonable cash flow, who have got, who have borrowed lots of money, particularly if they borrowed along at fixed interest rates.

RUSSELL NAPIER: And therefore it’s difficult to then turn around and say, oh, by the way, you should also invest in these people who are lending lots of money. And the difference may be just the time horizon.

STEPHEN CLAPHAM: And I I I don’t have the history of what happened in the 19 seventies to the banks. But when money was worth less, if you’re in the business of lending money, when somebody repays the loan, it’s actually got less real value. So did banks suffer from that?

RUSSELL NAPIER: Well, it was complicated because they went bust in 1974. So Natwest was probably bankrupt, but it was for a different reason. So if you’re looking at the total return over the seventies, it’s very difficult to out this great financial collapse that came along in 74 the secondary market banking banking crisis and the and the near destruction of Natwest.

RUSSELL NAPIER: So but I mean, my view is on the whole, it wasn’t a good place to invest in that period. There were much better places to be investing in the post World War Two, financial repression. And in banking, remember this was called 363, banking, lend, take deposits at three lend at six and on the golf course for three.

RUSSELL NAPIER: Yeah. And the reason you could be on the golf course for three is there was a limit to how much credit you could lend. If there’s credit controls, it was all gone by, it’s all gone by 2 30.

RUSSELL NAPIER: So you might as well go to the I, I, you know, I do get accused of being over pessimistic, but it seems to me that’s the perfect banking system for the new era and all our politicians will, will love it. What do you pay for that sort of banking? I don’t think you pay much for it, but as I say, I have difficulties because cyclically they might surprise or cyclically they will surprise.

STEPHEN CLAPHAM: Well, if they’re on a very low rating, it’s sounds like the odds are in their favor. Now, listen, you’re quoted Russell on the dust jacket of the, of that book Capital Account. What got you interested in that subject?

RUSSELL NAPIER: Yeah, I’m on capital returns. I was just a young whipper, snapper, just a mere boy when Capital Account came out.

RUSSELL NAPIER: So the Q ratio got me interested. So I run a course in finance and as you know, I know, I don’t know one end of a company from the other.

RUSSELL NAPIER: But I did come across Tobin’s Q which is a measure Tobin used to write, I would say he wrote about the capital cycle. It’s fascinating if I mean, it’s in different terms, clearly the terms of an economist, not a stock picker and even Keynes, I think wrote some stuff that you could say is to do with the capital cycle. So I obviously came to it from that angle.

RUSSELL NAPIER: And we, in my course, we look at the mean reversion of Q and, and the cyclically just a pe but of course, most fund managers want something that’s intensely practical. They don’t want kind of theoretical stuff. So they all kept saying to me, does it does have any relation to how you pick stocks and the obvious relation where it fits somewhat but not perfectly is the capital cycle.

RUSSELL NAPIER: So I was brought to the capital cycle from a top down approach and then because I’ve known Jeremy for a long time and we had long discussions in 1995 about the capital cycle in Asia and its imminent collapse. I can see that there was some sort of crossover.

RUSSELL NAPIER: I mean, what I was writing was, was really monetary stuff. And when I sat down to talk to Jeremy, what he was talking was about the misallocation of capital and overvaluation because of it and I could see the the blend. So I think it’s been a developing interest for me for many years, but it links from the top down from the, the, the Q ratio.

RUSSELL NAPIER: Tobin’s Q, I think it fits quite nicely with the capital cycle. And therefore there may be an overlap between the monetary economics which Jeremy originally set out to pursue and the capital cycle, there could be a link between them. They’re not completely divorced. There is a synthesis there which you know, I think is really, really interesting.

STEPHEN CLAPHAM: Do you have an ability to look at the queue on a stock or sector level, Jeremy?

JEREMY HOSKING: And do you look at the replacement value of assets when you’re investing, we look at the replacement cost of the assets and relate it to the current enterprise value or market cap of the company in so far as we are able and these are very sort of rustic calculations.

JEREMY HOSKING: But as Kane said, the goal is to be roughly right, rather than precisely wrong, but it’s a really difficult thing to do. But the the period of which Russell speaks, you know, I was perplexed by why these companies were growing so fast in reasonably mature industries.

JEREMY HOSKING: And the answer was the key ratio because if your, if your market value is three times the cost of building things, you can create $3 of shareholder value by spending $1 of capital.

JEREMY HOSKING: And that’s what they were all doing and compounding it in a pre Asian crisis by borrowing foreign currency terms and not hedging the currency. So the earnings were inflated on top of the impending doom of oversupply which Julie arrived in 1998 77.

RUSSELL NAPIER: Of course, I did, I did brew brew myself my own beer and I did, I did call it roughly. Right. That was the name of the beer. I thought that was appropriate in the circumstances.

STEPHEN CLAPHAM: But this, I mean, how did that crystallize in 1997? Do you want to just explain because you, you go into it in your book?

RUSSELL NAPIER: Well, I I’ll explain it and try to see where I think there’s a synthesis between the two approaches, which is, it’s obviously that the cost of capital is wrong and financial capital is abundant. And when financial capital is abundant, it has to have an impact on the supply of real capital, productive capital, which I think is what Jeremy has just explained.

RUSSELL NAPIER: The the problem was that the fund managers extrapolated that and believed that this was the status quo that somehow this was the system that would always be there, that there would be an abundance of this capital. And as Jeremy pointed out quite a lot of it was actually foreign currency debt capital as well. And of course, nothing goes on forever.

RUSSELL NAPIER: Hard to believe sometimes when you look at what happens in financial markets, but nothing goes on forever. So my job was to say that it was coming to an end and there are lots of ways that I tried to do that. But fundamentally, it was this, they all run current account deficits.

RUSSELL NAPIER: And as time progressed, the current account deficits were increasingly funded with short term capital and not long term capital, not foreign direct investment. So it wasn’t an outrageous forecast to say that one day, the short term capital, the portfolio capital wouldn’t come. And when it didn’t come, the price of money would go up as we saw in the United Kingdom in 1992.

RUSSELL NAPIER: And all of this would come to an end. The question, the only problem was keeping your job long enough to for it to come to pass. And of course, one day it came to pass, the cost of capital went up and the massive malve was evident for everybody to see.

RUSSELL NAPIER: And then of course, they devalued the exchange rates and if you’ve got lots of foreign currency debt, funding local currency assets and you devalue the exchange rate, but it really happens. So it was nice at that time to speak to Jeremy as kind of a lonely bear to hear someone from the bottom up, sort of confirming what I thought that this was some form of insanity going on.

RUSSELL NAPIER: The question was what would turn it around? And to me it was it was reflexive. So reflexivity just putting the financial capital in was changing the fundamentals because in a managed exchange rate, you forced them to create liquidity.

RUSSELL NAPIER: But when you brought the financial capital out, you would change the fundamentals back the other way. So there were no fundamentals, there were no fundamentals. The fundamentals were the product of a really bizarre monetary system and the world is full of really bizarre monetary systems. They come in all shapes and forms and I think that creates great opportunities for investors.

RUSSELL NAPIER: But it’s nice to have a look at the capital cycle to know where you are. And nobody was looking at the capital cycle and back to what Jeremy said earlier, really funny that the main tool of valuation in those days was the pe band chart.

RUSSELL NAPIER: And you mentioned earlier that you made mistakes, buying things because they were no pe s and every time I would walk in to see if a manager in 95 or 96 they would show me this pe band chart and they would show me that it had been at 17 times and it was already at 14 and this was the lowest ever in the history of the world. Actually, the chart ran to 1991 usually.

RUSSELL NAPIER: And how could you not be a buyer of these equities? But it turned out that the e was a monetary fabrication. And that’s why, you know, ever since then, I, I’ve tried to try to relate monetary systems to the allocation of capital, the fundamental and businesses without knowing one end of a business from another.

STEPHEN CLAPHAM: You do know one end of a business from the other, but one thing that you, you know, that’s coming out of this is we’re in the same sort of field today, aren’t we? Because there’s just all this capital going into tech.

STEPHEN CLAPHAM: I mean, I read in Bloomberg Business Week the couple of weeks ago that there were now 1000 unicorns, which is some trillions of dollars. Well, I mean, how does this all end up? I mean, you, Jeremy think it all, it ends up by the, the value of the big tech stocks going down a lot.

JEREMY HOSKING: Well, we will see, I mean, we’ve, we’ve, we’ve tried to run almost every argument on this topic and the growth stocks go up and the value stocks go down.

JEREMY HOSKING: I think until possibly the last 18 months when I think the situation is a bit different than the, the high tech sector. I mean, of course, the, the, the icons of the growth universe are such very remarkable companies. This wasn’t the case in 1999 2000, the dot com bubble, of course, because they were dependent on external capital and you didn’t know what terms they’d raised the external capital.

JEREMY HOSKING: So fundamentally, you couldn’t do a per share calculation on any company in the T M T sector. It was very tricky whereas now you can, and of course, those M PV S are very high and they’re inflated by very low interest rates. So we’ve been looking what’s gonna create mean reversion. So I mean, perhaps the Q ratio is mean reverting, but there hasn’t been much sign of that in the last 15 years.

JEREMY HOSKING: And one forgets that at the beginning of Apple’s great run in about 2008, Apple was a company with negative on our basis of looking at things. It was a company with negative value because the market cap was less than the company’s rainy day fund. This was just after the creation of the ipod, but before the launch of the iphone, so it was analyzable then that it should have the equity should have positive value.

JEREMY HOSKING: And so obviously, we asked Apple’s CFO why they didn’t buy all the equity back? So that’s an interesting question. We have long board meetings about it and some of us want to buy back the equity and others based on experience say we must keep the rainy day fund because we just know something’s gonna go wrong.

JEREMY HOSKING: But of course, nothing’s gone wrong. So they’re now buying back stock at a market value enterprise only about two or three trillion or whatever it is rather than buying it back at zero. So maybe that’s how these things are being reversing.

STEPHEN CLAPHAM: It’s funny maybe the the damage is done further down the chain. I mean, I guess that, you know, some of the big tech stocks have got very resilient business models and actually not such staff valuations. So, you know, Google or even a, even a Facebook or meta, the valuations aren’t that daft.

STEPHEN CLAPHAM: And if I’m not sure that Facebook is going to completely stop growing because I think, you know, small businesses are going to carry on advertising, whether there is 200 or 205 billion people on the, on the, on the channel.

STEPHEN CLAPHAM: So we’ll, we’ll see what happens with that. But I think there’s probably there’s a lot of damage to be done in the private markets which is obviously less visible and we can’t see where the, where the valuations are.

STEPHEN CLAPHAM: But the Q ratio one, I mean, one thing that strikes me about that is it’s very difficult as you move to a stock market which has got more intangible assets than tangible assets. The QE ratio becomes less relevant. Is, is there a way of squaring that is it? I don’t know.

RUSSELL NAPIER: Well, we on the, the court side, we just check it against cyclically adjusted pe which is a measure of earnings. It’s not a measure of any form of asset whatsoever and they stay very close and which is suspicious. Strange and a bit peculiar because the point you make seems like a good point and yet they don’t stray too far from each other over time.

RUSSELL NAPIER: And of course, we have a rapid acceleration in the intangible valuations. But there has been a drift in that for quite a long time, particularly with with brands more before technology. So for whatever reason, and not one that I can perhaps logically explain the cape and the queue stay pretty close.

RUSSELL NAPIER: Suggesting that somehow the queue is picking up what you need it to pick up. Jeremy’s point is the important one. I mean, it looks like queue doesn’t mean rever anymore really, since I would say 1995 is when it seemed to lurch off into what Irvin Fisher once famously called a permanently higher plateau.

RUSSELL NAPIER: But I suggest in, in my book on the Asian crisis that that’s a product of a very peculiar monetary policy that’s been in place since then because that was a devaluation of the rein. And I think they’re desperately connected.

RUSSELL NAPIER: And that forced a lot of capital into America from the Chinese forced on interest rates, forced on inflation, created a abundance of financial capital which was used to gear the hell out of anything with the cash flow.

RUSSELL NAPIER: Actually, you didn’t even have to have a cash flow, you could get the hell out of it. So my opinion and it’ll be right one day maybe is that the is definitely a mean reverting thing. And that time has come because we have changed the monetary system away from that.

RUSSELL NAPIER: Volcker used to call it the the hybrid system to something different. So the monetary distortions will be very different. They’ll always be there, but they are different money distortions and I think we’ll begin to see the main reversion of the, if I’m right, that major fund management groups are, are compulsory liquidators of large cap stocks and there’s even more Chance that it’ll be mean reverting. So we’ll see.

JEREMY HOSKING: So, should we just turn to, I mean, I can, I just, yeah, I think you can do something about intangible assets.

JEREMY HOSKING: And in fact, there is an essay in Capital Account about the valuations of drug stocks and drug stocks have been on a huge bull market run. And the, the mother of all drug stocks was Pfizer.

JEREMY HOSKING: And the insight we had then was that a pharmaceutical company consisted of two parts, there was the science department run by scientists in white coats and there was the existing products and that business was run by lawyers and sales reps, but particularly by lawyers.

JEREMY HOSKING: But because you knew the value of the market cap and because you knew the value of the in place product base, because those drugs would eventually go off patent and have a very low N PV. The residual was the the value being placed on the new products. And so in the case of Pfizer, we took the research and development budget, we capitalized it by the highly scientific method of multiplying it by eight.

JEREMY HOSKING: And it turned out the residual value on the QE of the science division was eight times. It was simply a staggering valuation and needs to say the, the share performed very poorly for an extended period after that as, as, as the air came out of the what appeared to have been a bubble.

JEREMY HOSKING: So I think you can do something about intangible assets even if it’s something as rustic as just multiplying the, the marketing budget or the R and D budget by 10.

STEPHEN CLAPHAM: Yeah, I think, I think the problem with, with that for some of the tech companies and particularly some of the newer SAS companies is that there, there’s a lot of massaging going on about exactly what they’re spending on marketing, what they’re spending on R and D.

STEPHEN CLAPHAM: And certainly I’ve looked at a number of these stocks where, you know, they’re making losses, they claim to have a viable business, they claim to be spending huge amounts in marketing and it, it, the numbers just don’t add up, but a lot of the problem arises from the accounting.

JEREMY HOSKING: Yes, which depreciates these things over one year’s expenditure. So they appear as something that’s negative in accounting land. And remember the databases used by value investors traditionally are based on accounting derived data in the databases.

JEREMY HOSKING: So I, I, I think there’s a confusion here between economic reality and accounting, which has led to this theory of intangible assets simply doesn’t translate into some sort of value paradigm. I, I don’t think that’s correct. I think it can do.

STEPHEN CLAPHAM: No, I, well, I mean, the accounting clearly didn’t fit for fit for purpose because the accounting rules were designed for, you know, a time when there were fixed assets factor can be written about the accountants.

JEREMY HOSKING: Otherwise this interview is going to go on forever.

STEPHEN CLAPHAM: Well, no, we shouldn’t because you, you might not know this, but Russell was actually very accomplished in the field of accounting. Russell. Do you want to up to your, to your skills in this area? Or would you rather have the secret remained buried?

RUSSELL NAPIER: I’ll reveal it today for the first time because Jeremy may never speak to me again. But in 1991 setting, the set the Society Of Investment Analyst UK exams, I won the prize for best accounting paper, Jeremy. So I hope you’ll forgive me. I mean, I’m, I’m not in some form of purgatory.

STEPHEN CLAPHAM: I, I’m full of admiration because this is a fact and I didn’t know about you. And so see, one of the nice things about doing the podcast is you have to do research and you guess, and you get to find out that this is actually buried away in one of Russell’s many biographies.

STEPHEN CLAPHAM: So society in Investment Analyst exams, for those of you who aren’t. Geriatric is the predecessor organization to the C FA Society, which I’m sure most listeners to the podcast will be, be aware of.

RUSSELL NAPIER: I received a lovely silver plate and 500 quid and the 500 quid was a lot of money in 1991 and I invest it wisely five £100.

STEPHEN CLAPHAM: That’s an amazing price.

JEREMY HOSKING: Well, Steve could I just, I mean, I think the mean reversion problem in valuation between the haves and the have nots is more likely to be solved by the have nots because they have more control over what they do. And that’s partly why I went on that rant about banking.

JEREMY HOSKING: They, by cutting their capital spending to, effectively to nearly zero, they can use their free cash flow from their depreciation to buy back the shares and eventually good things will happen and that will shrink their balance sheet.

STEPHEN CLAPHAM: They, the capital spending that they’re undergoing, they don’t need to, to do because they don’t need branches anymore and they, their legacy systems will have to be binned. They’d be better off starting.

STEPHEN CLAPHAM: They be, I mean, one theory about the banks is it’ll be better off just sort of shrinking to zero and letting the revolut of this world take over their business and they shrink to being a commercial lending business without, without so much on the other side of the balance sheet. Would that be the, the solution you would look at or?

JEREMY HOSKING: Well, it’s what I would be trying to do if I was on the board of Lloyd’s Bank. Yes.

STEPHEN CLAPHAM: Well, I’m sure that the polls will be ringing. I’m sure.

JEREMY HOSKING: I don’t think so.

RUSSELL NAPIER: I think they’re aware of my views and I don’t think you’d accept that.

STEPHEN CLAPHAM: So, listen, Jeremy, you, you, so I’ve alluded to it earlier. You know, today many investors and professional fund managers have embraced concentration. I mean, Nick Trains, probably one of those very concentrated fund managers. Terry Smith’s the obvious other example, you hold a few quality stocks, hold on to them for a long time.

STEPHEN CLAPHAM: You’ve got a very unconventional approach because you’ve got a lot of stocks in your portfolio. So it sounds like a recipe for a benchmark hugging. Actually having, you know, a large population of stocks, you just talk about why you’ve adopted that system and why it has worked.

JEREMY HOSKING: How many stocks, how many it hasn’t worked very well over the last eight years. I mean, our returns over the last eight years or so are slightly below the index in the context of the sort of the market. It’s been, that’s in my view, not too bad a result, but that doesn’t put bread on the table for pensioners.

JEREMY HOSKING: You had to beat your benchmark and we found that very difficult in the, in the growth world, I suppose it started really from the conundrum of what do you do as a fund manager if you’re very successful and your success has been based on some sort of discipline, it doesn’t matter what the discipline was, but you followed it and miraculously it turned out to be right.

JEREMY HOSKING: And, and the pension funds, you’ve never heard of are knocking on your door and trying to give you money.

JEREMY HOSKING: And, that’s what was happening to us in the, in the decade of the noughties. After, after we’d very much distinguished ourselves by going pro value in 99 2000, therefore avoiding the dot com collapse. So the money is coming in. And, what do you do?

JEREMY HOSKING: Because you’re, you, you either buy, you either with your money, buy a smaller number of blue chip stocks because you will preserve your maneuverability, which is fantastically important to fund managers for some unknown reason.

JEREMY HOSKING: But of course, one of the reasons it’s popular is it’s popular with the compliance people. You, they know you can get out of Pfizer in an emergency if there was to be one. Whereas if you’re in Diana shipping, it’s not so clear you can get out in an emergency.

JEREMY HOSKING: So the pressure is to you get your record and because some managers as they become more successful, one of the bizarre ironies is they become more and more interested in becoming more commercially successful. They don’t become more and more interested in becoming better investors. It’s one of the cruel get jokes that the gods have played on us.

JEREMY HOSKING: So the focus becomes more on a U M rather than return a U M growth rather than return on the existing A U M and they drift up into the blue chips, which are not necessarily the investments, which created the record in the first place. The other one other thing you can do is ok.

JEREMY HOSKING: So I’ll continue to buy midcaps which gave me this record, I’ll just buy more of them. Well, the market place in which we live hates that with a vengeance. And a lot of the reasons, there’s, there are many reasons for it. Lack of conviction, closet indexing. Well, I don’t think any of those things really apply to us, but you and the people who advise big funds.

JEREMY HOSKING: Well, I can create your 400 stock portfolio by hiring 20 managers with 20 stocks which is by and large what funds are doing, but the same 20 stocks, not necessarily, one might be in Coke and the other might be in Pepsi different stocks. You see.

JEREMY HOSKING: And so well, the proof will be in the pudding about how these very concentrated portfolios perform. My hunch is that they have are massively gross growth biased because that’s what’s worked.

JEREMY HOSKING: They’re massively size biased for the reasons around liquidity, promoted by the compliance people. And we’ll see how it does. I mean, I, I, I think our portfolio of 400 of which let us say 380 are very inexpensive. I think it’s going to do quite well.

STEPHEN CLAPHAM: I’m sure it will, but just talk a little bit about you. You said that you’ve had a difficult period and an extended difficult period. How do you cope with that because there must be tremendous pressure for your clients. There must be tremendous pressure from your colleagues. I mean, you’ve been doing this for a long time and you’ve presumably, you’ve had periods in the past where you’ve haven’t done as well as you’d hoped.

STEPHEN CLAPHAM: What, what’s the secret to surviving a difficult period? Because I’m sure lots of, lots of listeners will be thinking about their own portfolios and wanting to get your, how do you, how do you keep your, how do you get up in the morning and feel, feel cheerful and not make the wrong decisions?

JEREMY HOSKING: Well, Russ will know the answer to this. Who was it? Who said if, what about the bandwagon effect that it can’t roll on forever? It won’t. I think it’s a law, isn’t it?

JEREMY HOSKING: So it’s nice to know about inevitability. Inevitability helps you with the patient’s problem over the last few years. With growth stocks, a limited number of growth stocks performing so well. It’s become, it’s really quite difficult to make that argument. So, in Russell’s world perhaps is the inflation will rise and interest rates still won’t go up.

JEREMY HOSKING: And I, I, I think it’s gonna be critical whether the central banks buy the bullet and decide to sell the long bonds, they’re built, they’re bought. But if they do sell them, that should steepen in my view, that the yield curve should start to steepen, there’s no sign of the steepening of, of the yield curve but they haven’t sold any bonds yet. So we, we’ll see what happens.

RUSSELL NAPIER: I think it’s fascinating. I think everybody is in the, in the value growth sector is looking for interest rates as the key determinant as to when the shift comes. I think it’ll be a different one. So if you hold yields down by forcing savings institutions to buy them and save, sorry, sell equities, that revert, that reverts. That is when value will significantly out on growth because they’re all clustered into growth.

RUSSELL NAPIER: But it’s, it is in no way. The traditional way that this would happen. The traditional way this would happen is exactly as Jeremy says, that interest rates would start going up to reflect higher inflation and that would be the beginning of the rotation. So nine out of 10 bearers will tell you interest rates are going up and the market is coming down.

RUSSELL NAPIER: I’m the one out of 10 bearer who says that there’s a whole new devious way in which the rotation from growth to value can take place. And you know, obviously I’ve got a pretty positive view on the, on the earnings for some of the value stocks as well because of this change in the nature of things. So that is most people would say, well, you’re unlikely to be right on that because it’s such a rare thing.

RUSSELL NAPIER: Usually it’s interest rates going up. So if I’m gonna be right. I’m gonna be right for a very rare, rare and peculiar reason.

JEREMY HOSKING: Then there’s our, and the law of unintended consequences. And I think probably the, the mania for setting up E S G funds and the consequences of E S G funds not being where you should invest. I think it’s a record for a strategy going wrong because look what’s happening to the commodity and the fossil fuel prices and you can see why the supply side is fantastically powerful.

JEREMY HOSKING: Yes. No, they, once you’re not allowed to invest in these things, it’s not a short, it’s a short lag between the oil companies deciding they hate their core business and the core business becoming very profitable. And exactly the same thing happened to the tobacco companies 20 years ago. It was the best sector of the market.

RUSSELL NAPIER: I had an interesting meeting with the man who runs a metal bashing company in Spain. And I said to him, what would you do if tomorrow morning you had to make this company more green.

RUSSELL NAPIER: And he let out a huge sigh and said, I’d have to buy Japanese steel, which I thought was a fascinating answer because if you really are into E S G, you should be buying Japanese steel because it’s one of the lowest carbon emitting forms of steel to be produced.

RUSSELL NAPIER: And by definition, we will be consuming steel next year, the year after and the year after and yet my understanding of how E S G approach, this is to say no steel or something to that effect. So we need a more nuanced approach to this.

RUSSELL NAPIER: But I obviously, I think it’s fascinating in relation to the capital cycle which I read from top down, not bottom up in Germany. If you Jeremy, if you begin to staunch the flow of financial capital to a sector, then eventually my understanding of the capital cycle is eventually the returns will go up.

RUSSELL NAPIER: So this E S G by being kind of blanket indiscriminate is creating opportunities for investors in, in firms, I strongly believe will be seen as green in a few years from now if you make green earth steel, but it’s not green steel, but it’s green our steel.

RUSSELL NAPIER: Why isn’t that part of the green solution? And if you’re funding Capex to build more capacity on green earth steel, because we’re not buying Chinese steel, then you’re part of the solution.

RUSSELL NAPIER: You’re not part of the problem and the fashion shifts. And let’s see if the E S G fashion shifts to something more reasonable. And that’s the time when the capital cycle would I think as a non expert on the capital cycle turn in the favor of those types of stocks.

JEREMY HOSKING: I mean, I’ve spent quite a lot of my analytical life trying to get capital intensive businesses to invest less.

JEREMY HOSKING: And thanks to the thanks to global warming, I’ve finally got my wish who would have funk it.

JEREMY HOSKING: And in fact, the same applies. Clearly, a lot of these businesses should be, should be trying to get smaller, not in necessarily in terms of reserves, but in terms of annual output or in the case of an airline seat miles flown per year, they should be trying to get smaller because that’s the only way they can guarantee the emissions go down.

RUSSELL NAPIER: Would your opinion be the same if we stopped trading with China on a point of Prince?

JEREMY HOSKING: Well, this is in the, the whole debate is quite interesting because while most of our managers were busy ticking boxes, we sort of took a rather detached view of the not so much the sustainable business and governance thing, but traditionally, we’ve been quite hot on that, but on the environmental side, and we’ve been persuaded by our clients that we really do need to focus on this.

JEREMY HOSKING: And what we have now is I think an example of a last mover advantage because the ultimate, the, the reason there is a, a global problem, if there is a global problem is because of excessive consumption of Chinese coal by industries that we have put in China.

JEREMY HOSKING: So quite what the farm manager is supposed to do about this, I’m not quite sure. I mean, it’d be fair enough to possibly order them to divest from Chinese coal mines, but that doesn’t solve the problem anyway any more than divesting B P helps really, it’s simply owned by somebody else. And those in those arguments have been quite well made.

STEPHEN CLAPHAM: I mean, it, it ends up in the, in the hands of private equity who have, haven’t got an E G manager or compliance person.

JEREMY HOSKING: Well, they have the same client so they’ll be drawn into it too.

JEREMY HOSKING: But I if the why would you, so the fund management industry has become obsessed with the first derivative, whereas they should be focusing on the second derivative. And why would you ever invest on the first derivative when the second derivative is available?

JEREMY HOSKING: So in my view, carbon emitters that are getting smaller are going to be fantastic investments. And from a second derivative point of view, they’re moderately virtuous because they’re improving their, they’re lessening the carbon of their outputs.

STEPHEN CLAPHAM: Yeah, I think the, I mean, the whole S G thing has been just been extraordinary the way people have just applied a stuck, a label, stuck a sticker on, on, on the, on the product and called it E S G without any clue about about the or any clue about what it really means and any real thought process.

STEPHEN CLAPHAM: And it’s been fascinating in the past couple of weeks, seeing people say, well, the defense companies should be E S G now because that’s part of what we need, right?

JEREMY HOSKING: I mean, more bombs. Yeah.

STEPHEN CLAPHAM: I mean, it’s quite extraordinary.

RUSSELL NAPIER: The important thing in this business is to know who’s wearing a white hat and who’s wearing a black hat, but nobody seems to wear a gray hat. So knowing in advance who’s about to wear the black hat, I think who’s about to wear the white hat.

RUSSELL NAPIER: It’s probably quite a good way to make some money. But I think it’s quite difficult to see who fashion declares is the guy in the white hat and who is the guy in the black and talking about E S G here, not, not events in Eastern Europe.

STEPHEN CLAPHAM: The whole E S G thing has been quite extraordinary. I mean that when you, I, I looked at doing a course on E S G and I went and interviewed quite a few people who were real experts in the area and I came to the conclusion that it was something that was incredibly difficult to do a course on. And so I decided not to.

STEPHEN CLAPHAM: But when I was talking to people about it, you know, because the C fa of course, have brought out an E S G course and the, the C fa S G E S G course project is basically, you know, a list of the UN goals. And so, but there’s no holistic view of companies and the people who are really expert at applying E S G principles seem to be no, they didn’t have an E S G label outside their, their on their fund.

STEPHEN CLAPHAM: They just had been practicing this as part as an integral part of the investment process for decades. So they kind of understood, you know, what was going on, what was, what was a good company the same way as you, you’ve been very hot in governance for many years just on the G bet.

RUSSELL NAPIER: I am the chairman of a UK listed company.

RUSSELL NAPIER: And I received a letter from a shareholder suggesting that I should have more women on the board. So I thought that was interesting because we want to have a more diverse board.

RUSSELL NAPIER: So I wrote back asking for more guidance to diversity and, you know, in particular, you know, how you would define diversity, particularly, I give my background, whether they would consider that privately educated people dominating a board is a good thing or a bad thing or whether there should be more diversity from educational background.

RUSSELL NAPIER: And I received a letter back saying put a woman on the board. We can’t measure this other stuff. So we ain’t that interested, that’s not governance, that’s, you know, we will, you know, you, you, if you can measure it, you can manage it and if we can’t measure it, we can’t manage it.

RUSSELL NAPIER: There’s gonna be too much effort. So look, we can come back next year and suddenly they’d be really big on having people from non privately educated people on the board. Meanwhile, we’d be, we’d have a woman on the board who’s privately educated.

RUSSELL NAPIER: I mean, there’s no thought to it. So that’s my one practical experience with the bit that there isn’t a great deal of thought going into it. There’s a lot of box ticking going into it, but not a lot of thought going into it. No, absolutely.

STEPHEN CLAPHAM: That’s what you were saying is box ticking. Listen, you’ve both, gone it alone in the past sort of 10 years. I just wondered, I wanted to finish by just asking, you know, what’s it like, sort of working for yourself after a period, working in Russell’s case, you were working for a big brokerage or a large partnership, in your case, Jeremy.

STEPHEN CLAPHAM: And have, has there been any big lessons? Have you learned any big lessons? I mean, it’s not, not a surprise that you’ve both been incredibly successful, but looking back today, is there anything that you would have done differently knowing what, you know, now, I don’t know which of you?

RUSSELL NAPIER: Well, I’ll start and I work for a company called C L S A which never thought of itself as a big broken company. Didn’t behave as a big broken company. So I didn’t find myself constrained or traveled in the way that most people who work for broken companies are. So in, in my case, it wasn’t a, a major leap.

RUSSELL NAPIER: But the thing I’ve learned is I should have done it a long time because you get better clients because you get clients who are actually interested in what you’re saying. And quite often in a broken company, you’re trooped in to see somebody because they’re kind of available.

RUSSELL NAPIER: And the other thing I find in my doing what I do, I attract more principles as clients that agents or at least agents prepared to think like principles, which is an dying, dying breed. And it is much more fun because I learn much more talking to principals than I do talking to agents. So my, my lesson to anybody in this business or any business is if you can deal with principles, do it.

RUSSELL NAPIER: Because it’s, first of all, they’ve got, they’ve got much better incentives, you’ll learn a lot more. And I wish I had learned that lesson when I was a bit younger so that I could have structured a business around principles and other agents a bit earlier.

RUSSELL NAPIER: Now having said that most of my friends are agents, so I’m also quite friendly with agents and I like them as well. I need to be clear on that, but it’s good to have a mix. And I think if you surround yourself by a word of agents, I think you’re going to get a particularly perverse view of the world. So that’s my lesson from, from being independent, Steve.

STEPHEN CLAPHAM: Thank you, Jeremy. Have you got any reflections?

JEREMY HOSKING: Yeah, I’m, I’m, I’m tortured by what Charlie Munger says about asset managers as not being a very productive way to spend a life. So that really is your question phrased in a different way.

JEREMY HOSKING: And I look back on it and, I’ve had a, I’ve really enjoyed it. I’m not saying it’s been packed full of social meaning, but the, the challenges have been immense. And I think the particular one which Russell has alluded to, you have to drive in the direction of principles being a principal rather than an agent.

JEREMY HOSKING: Otherwise I think you just lose it. And that’s what we’ve tried to do a Marathon and here at Hosking partners and as time goes by, we would much rather have an investment in a highly liquid com illiquid company.

JEREMY HOSKING: 86% owned by the insiders only than, than a big company with a big free float that is li Liquid is water because in the family business, someone really caress and we ask ourselves that all the time, who really cares about this company delivering results in the long term because we’re gonna hold it for quite a long time.

JEREMY HOSKING: But the reason we hold shares for quite a long time is because other whole people hold them for a very short period of time. Therefore, the long term alpha can’t be discounted in the present price. Otherwise everyone will be a long term and they’re not.

JEREMY HOSKING: So it’s really an arbitrage as to where the alpha is if the world migrates. And it’s a, it’s a, it’s a development of the capital cycle approach which of course, was based on Groucho Marx is I wouldn’t want to belong to any club that would have me as a member.

JEREMY HOSKING: This also in our view applies in the behavioral field. If everyone’s a short term, the long term alpha must be enormous. And if it’s not, then the world works in a rather even more curious way than I thought it did before we finish in our last question.

STEPHEN CLAPHAM: I just wanted to ask you about football because I just recorded a podcast with Jim O’Neill and he’s been desperately upset about Manchester United and I looked at the Manchester United chart and Manchester United is the same price today as when it was floated 10 years ago. And S and P 500 is what trebled in that period.

STEPHEN CLAPHAM: I guess you’ve made money in the premier league. I mean, why is it just that the, the fact that the club’s floated at too high a price? And what when you look at Manchester United, you’re an expert on football, you’re an expert on invest, investment. What do, what should we make of it?

JEREMY HOSKING: Well, I’m not an expert on football. I mean, our, our at Crystal Palace, listen for the cheers. Our chairman and chief executive is 20% of the club personally and he is a very astute person and he’s able to mesh takeover fees with player salaries.

JEREMY HOSKING: And it’s the old accounting dilemma between expenses that are expensed and expenses which are capitalized and most people aren’t very good at thinking in those two entirely contradictory dimensions at the same time and meshing it together. And Steve is brilliant at that. You’re still a shareholder. Oh, they dilute me the whole time.

JEREMY HOSKING: And I protest and I’m ignored.

STEPHEN CLAPHAM: Well, listen, both of you. Thank you so much for spending your time before we go. I always ask people, if there is a book that they would recommend to a young person that was looking to come into the industry, Jeremy, do you have a recommendation, the book?

JEREMY HOSKING: I would recommend people to read and particularly younger listeners is a book called The Jones Averages by Bennett. Good speed.

STEPHEN CLAPHAM: Is there any particular reason why you, you chose that?

JEREMY HOSKING: Or there’s a wonderful chapter on the demise of the Titanic, which you will recall received a message from the Carpathian steaming in the opposite direction that there was icebergs ahead and that message got jumbled up in the guests of cables and never reached the captain.

JEREMY HOSKING: There’s a wonderful chapter and there’s also another cartoon with a would be investor standing in front of a chemical plant that’s burning and he’s saying to his broker to hell with a diversified portfolio. You’re to sell ABC chemical and sell it now?

STEPHEN CLAPHAM: Great Russell.

RUSSELL NAPIER: How about you? I think I have to spring to the defense here. I mean, as somebody who’s from Belfast, my father may have been a butcher but my grandfather was a sailor and my grandmother worked in the rope works and, and they, they watched that ship sail out and as they would always say she was all right when she left here.

RUSSELL NAPIER: I, I mean, it’s, it’s quite can I have two because it’s a boring one. But I think it’s essential, which is triumph for the optimists, which is the, the history of financial returns.

RUSSELL NAPIER: But that’s probably not gonna get any young person enthusiastic about our business, but it will get them calibrated to the possible and the population in general is entirely uncared to the possible. I know this because I live near pensioners and they wander in and say all I want is a sound 12% per annum.

RUSSELL NAPIER: So it is possible it’s really important to get calibrated. But, but why not the Money game by Adam Smith from the sixties which tells you how much fun it can be and how much delusion there is, how much psychology there is and how much there is beyond accountancy.

RUSSELL NAPIER: Because I think most young people think investment management is some sort of deranged form of accountancy. They may not be far wrong. But the the money game, let you know that this is, this is a sport for the Renaissance man or the Renaissance woman. And it comes out very well. I think of the money game.

STEPHEN CLAPHAM: It’s one of my favorites. Chapter 12 where he, he talks about the young ones where they don’t have the, they’re not, they don’t bear the scars of history.

STEPHEN CLAPHAM: I was listening to a podcast by, Shane Parrish, the Knowledge Project with Mark Andre Andre Horowitz and he talks about venture capital scars because of course what failed last time is probably going to work this time in venture capital. It’s quite, quite an interesting parallel. Thank you both enormously. I really appreciate your time. Thank you.

STEPHEN CLAPHAM: Good to see you.

STEPHEN CLAPHAM: Well, that was a fascinating discussion and one which I could have happily continued for much longer. Indeed, as soon as the microphones were spaced off, the discussion became more intense and actually quite funny.

STEPHEN CLAPHAM: Anyway, I hope you enjoyed this episode. Let me know what you think you can email me at info at behind the balance sheet dot com. We would love to get your feedback and particularly ideas as to how we can explore this really fascinating topic further.

STEPHEN CLAPHAM: Thank you.

STEPHEN CLAPHAM: So I just wanted to finish this podcast off with an additional session with Russell.

STEPHEN CLAPHAM: What we talked about with Russell and Jeremy was effectively what we were looking to explain was a capital cycle and major financial repression.

STEPHEN CLAPHAM: And Russell and I on the Monday following the Thursday that we did, the recording, Russell was back in London and we went to a presentation and met with David Einhorn and David Einhorn was talking about inflation and apart from his Macro hedges, he was hedging in the stock portfolio in three ways, he was buying stocks where there’s an element of price related fees.

STEPHEN CLAPHAM: So a good example of that is the payments industry. So where there’s a natural inflation hedge in revenues. He was also advocating stocks where there was a sunk cost that might inflate for its competitors.

STEPHEN CLAPHAM: So for example, if you’re a house builder and you’ve got a long land bank, that land bank is going to inflate for your competitors and that will allow you to inflate your margins over time.

STEPHEN CLAPHAM: And he’s also buying stocks and this ties in very closely with the capital cycle where there’s been a lack of investment and preferably where there’s been a lack of investment and there’s a long construction lead time which will allow the players to benefit from demand continuing to increase and supply, not keeping up. And a good example of that is the mining industry.

STEPHEN CLAPHAM: And so Russell, I just wanted to, to finish this podcast because I wanted you to explain your theory about why the capital cycle will be so important in an age of financial repression because we’ve had 10 years of falling rates and the growth stocks going through the roof. And that’s not going to be a simple way of making money in the stock market going forward. So, could you please just explain that view?

RUSSELL NAPIER: Sure. Well, the capital cycle relies on a relationship between the supply of financial capital and the creation of corporate capital and the two things are not always in balance and we can create a monetary system, that means they’re desperately out of balance.

RUSSELL NAPIER: I think that’s what we just did, Steve, I would call it the hybrid system. I stole that from Paul Volcker. And that was the linking of the Renminbi to the dollar and undervaluation. But frankly, after the Asian financial crisis, lots of people did that.

RUSSELL NAPIER: Now the consequences, people will find this hard to relate to the capital cycle. So bear with me. But the consequences of that is there was a profusion of financial capital available in the developed world.

RUSSELL NAPIER: Interest rates were depressed. These central bankers from the Asia and particularly the PB O C were buying lots of government bonds that held down interest rates. Of course, it freed up the saving system of the US as well to go in pursuit of other ventures.

RUSSELL NAPIER: It, it kept down inflation because they were exporting at very low prices. So that’s one side of the capital cycle, an abundance of financial capital. Now the other side was by holding down the value of their exchange rates. They made their corporate capital incredibly productive, not just the existing corporate capital, but everything that they then added to that.

RUSSELL NAPIER: And this is China was particularly egregious at this. And as we all know, added huge amounts of corporate capital all subsidized for a second time, not just by a cheap exchange rate, but also by very cheap credit from the state run banking system.

RUSSELL NAPIER: So that monetary system actually did have a huge role in the capital cycle. It depressed returns on, let us call them old economy stocks, not a phrase I’m not familiar with, but heavy asset stocks are capital, heavy stocks and of course promoted a huge period of financial engineering.

RUSSELL NAPIER: And not all the stocks that have led the stock market boom have been financially engineered stocks, but quite a few of them have and quite a few of them have borrowed money to buy back their own equity, et cetera.

RUSSELL NAPIER: And one things of spheres like private equity in particular, so their abundance of financial capital has been useful and what’s it been used for? It’s effectively been geared up gearing up existing income streams in the new monetary system. And there are many things about this new monetary system. But at the core of it, we are ostracizing China from the global trading regime.

RUSSELL NAPIER: We are going our separate ways now potentially very quickly indeed at the moment and that hybrid system is over and the system that replaces it is each individual government attempting to inflate away its debts now without going into detail on that.

RUSSELL NAPIER: What it means for the capital cycle in the age of financial repression, the end of the period of hybrid monetary system and the birth of financial repression is there’s a lot less competition for coming from China. And the Chinese ability to add ever more corporate capital is reduced.

RUSSELL NAPIER: So the value of the corporate capital that exists today in the non China bit of the market which may be not just China, China may have allies in this. They may be on the same side of this wall that China is going to become in. So we should expect higher returns from that corporate capital.

RUSSELL NAPIER: But at the same time, a much reduced supply of financial capital. The governments, we can see this even in since the outbreak of this war where the governments are needing this financial capital, steering it towards other bits of society.

RUSSELL NAPIER: Other bits of the economy, energy diversification being obviously top of the agenda, but there’s plenty of other things in terms of green agenda. So the financial capital that was once used for financial engineering is being pushed and the return on the corporate capital that we’re not dealing with. China is going to go up.

RUSSELL NAPIER: Now, that’s a revolution for me in the capital cycle. We all know everybody listening to this will know that value investors have had a particularly difficult time for several years now in the death rows of that hybrid system. But in this system, the meek shall inherit the Earth Russell.

STEPHEN CLAPHAM: That’s a brilliant quote to end it with, we will need to really explore this subject. I think at a later day because one of the other issues is that, you know, loads of that financial capital has gone, chasing the opportunity in venture capital and then tech and that’s another consequence.

STEPHEN CLAPHAM: And we’re obviously we’re entering a period which none of us have the experience of. So there’s going to be lots more to talk about. But thank you so much for your time.