A Portfolio For Uncertain Times

Chinese Tech Growth Stock or Doom Mongering? Why Not Both?

Missing Money

In investing, a lot of money lost is in what you miss.

It can be missing a risk or a change in an industry causing stock losses.

But more often than not, it is not buying something. Not buying Microsoft in 1995. Not buying Amazon or Apple in 2002. Not investing in oil and energy in 2020.

Another one I suspect will be added to this record is not buying Chinese tech stock with strong growth at a P/E of 15-20 and after a 50-70% decline.

The problem is of course that for each of these cases, there is at the time a compelling narrative of why these sectors have been hammered into oblivion. The DotCom bubble explosion, the 2008 Great Financial Crisis, negative oil prices and renewables, each “felt” compelling at the time.

The alternative of taking a systematic contrarian approach does not work either.

This is how so many contrarians stayed in Russian stocks when Russia itself was making it clear it was going to invade Ukraine. I managed to leave with my Gazprom gains then, but barely 2 months before having my position wiped out is a too much of a close call for doing that regularly.

The Investing In China Conundrum

Regarding China, I feel it is a similar issue to where Russia was in 2021.

The more it goes, the less I envision a scenario where either China or the US backs down.

On one hand, the US, already on the verge of a humiliating defeat in Ukraine, cannot let Taiwan be taken over by China, including by peaceful means /diplomatic reunification.

On the other hand, China cannot let Taiwan be turned into an impregnable fortress to blockade its sea lanes and lifeline of energy and food imports. The matter of national pride and of “reunification” does not help either.

This is the same way that Russia could not back down and let Ukraine turn into a hostile state at its border, being reinforced with even more weapons and military infrastructure. If anything, the consensus in Russia is now that Putin waited too long.

So Is War Inevitable?

Of course not.

More rational minds might prevail.

Or one country might be distracted by internal issues and let the Taiwan question wait for at least another decade, from US political dysfunction to potentially China’s internal economic shock.

They might also play out their rivalry somewhere else entirely.

Maybe a conflict in the Middle East, as I explained the possible Azerbaidjan-Turkey-Israel vs Armenia-Iran-Russia war risk in the Caucasus. Add the USA and China to these, and you have a “World War” where both China and the USA are likely not considered as “official” participants in the conflict.

In this scenario, US and Chinese stocks would probably be a safe haven out of the central Eurasia devastation, in an axis going from Ukraine to Syria.

So not knowing how things will play out, it might be entirely irrational and wrong to avoid Chinese stocks. We are talking of the largest economy in the world in PPP, and by far the largest industrial power on the planet.

All while the power of freshly printed money started to fade in the West, with inflation a much more persistent issue than “expected” by our half-wit leaders.

Can investors really ignore China for the whole of the 2020s and perform well?

The Barbell Strategy

One strategy I see discussed but rarely applied is Nassim Taleb’s Barbel strategy.

The idea is to have a portfolio that is exposed to ALL long-tail risks, both positive AND negative.

"If you know that you are vulnerable to prediction errors, and accept that most risk measures are flawed, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative."

Different Eras, Different Portfolios

I think this is going to be especially relevant for the years to come.

If you were investing in the 1950s or 1960s, a conservative buy-and-hold approach of quality stock probably worked well. This was a post-war, stable period with plenty of growth and positive trends in demographics, technology, and geopolitics.

Basically, as long as nukes did not start flying, you would be right to count on a stable economic and international system. And if they did, your portfolio would not be very relevant anyway…

However, such an approach would have been financial suicide in the 1930s. These times were obvious powder kegs waiting to explode.

Starting with the 1929 crash, followed by the Great Depression, then hyperinflation in Germany, communist agitation and coup tentatives in Europe, the rise of fascism and nazism, and the expansion of the Japanese empire.

Any of these could and ultimately ALL would hurt investors. With the benefit of hindsight, US investing was the best idea. But at the bottom of the Great Depression, it was far from obvious the USA would emerge as the ultimate winner of such international disorder.

The Incoming Event Horizon

By 2030, we are likely to see the 2023-2028 period as only 1 out of 2 possible scenarii:

1. The prelude to a great catastrophe, probably remembered as World War 3.

2. A moment of needless worry where “smart” investors ignored doom-mongers and went all in on Chinese, energy and nuclear stocks.

   1. As the saying goes “History is written by the victors”. This clearly applied to financial markets as well.

In truth, it is essentially impossible to determine which is the likely one at the moment.

This is reminiscent of how the Trading Guild navigators in the Dune novel cannot use their gift of prescience to see beyond a specific event in the near future. The sudden incertitude ultimately paralyzes them into inaction, causing their doom.

Such historical event horizon is resistant to all prediction tentatives.

Investors are similarly at risk of freezing in place, like a rabbit in front of a fast incoming car.

There are moments in history when ANY actions might be better than the paralysis of business-as-usual.

Asymmetries & Hidden Correlations

Another crucial idea in investing is to properly use asymmetries.

You want to do investing bets where you lose 20-30% when you’re wrong, but win x5-x10 if you’re right. George Soros’ and Druckenmiller’s careers have been based entirely on this concept.

As investors in Russia recently discovered, this concept breaks down when the downside risk is 100% loss.

In theory, you mitigate that by diversifying the risk widely, so only a few bets go to 0.

In practice, good ideas come rarely, are often connected, and sudden hidden correlations can wipe you out more often than not.

Imagine a 25-25-25-25 US/Emerging/Energy/China stock portfolio.

Pretty diversified right?

Still, what part of it performs well going into WW3?

The US and China would probably tank horribly. Energy as well, as the world’s supply chains break down into a new Great Depression and war economies. Maybe emerging markets are the least bad, but unlikely to do well either.

Alternatively, if nothing major like a great war happens, this will likely bring mediocre returns at best, maybe 7% if you’re lucky.

Doing everything at once rarely brings a good return on capital.

So the conventional approach is likely to be a lose-lose scenario, no matter how this decade plays out.

Mere diversification and prudence will not work.

Known Unknowns

Despite the instability, we can make a few safe predictions.

1. Deglobalization will happen no matter what.

   1. It is fueled by so many factors that it is unavoidable: strategic & military concerns, great power rivalries, domestic populism, and rising protectionism from industrial lobbies.

2. The outcome of the US-China tensions is binary: Peaceful de-risking/separation or open conflict.

   1. Friendly relations are very likely impossible. The US will never accept China as an equal in the short term, and China will never accept to be “contained”. Decoupling is a certitude that the markets are only starting to comprehend.

3. Open conflict means a Global Depression.

   1. The shock to supply chains, as well as money (and lives) destroyed by the military would be too devastating to avoid it.

   2. For Westerners, it also means losing all the money they put into Eurasian stocks.

4. Peaceful decoupling means sanctions and global trade and tech reorganizing, but no hard break.

This knowledge should inform us about the strategy to adopt. We want to end with positive returns no matters what, for BOTH an open conflict and peaceful decoupling.

A Barbell For Our Times

Sector picking

Now that we properly framed our thinking, we can build a Barbell portfolio able to BOTH be:

1. Extremely conservative and bearish, only focused on risk:

   1. What assets would work well in case of a global conflict erupting

2. Extremely aggressive and bullish, only focused on growth and innovation:

   1. What assets would perform well if China, India, Indonesia, Latin America, Africa, etc. keep developing?

For the first part, we want assets that have some of the following characteristics:

• Historically a safe haven from global crises.

• Inversely correlated to growth stocks.

• Easy to protect or move out of the financial system.

• Produces good yield.

• Has a pricing mostly independent from the global economy.

• Has very inelastic demand.

• Would be in shortage if international trade breaks down.

• Would benefit from a global conflict.

For the second part, we want assets that have some of the following characteristics:

• Benefit from rising global income and growing global middle class.

• Can be reasonably expected to grow strongly in the next 10 years.

• Is currently cheap enough to not price in properly for future growth.

• Is in short supply for the foreseeable future.

• Has quality management and good ROIC.

The Defensive Part

This is a rather short list that comes to my mind, of which I have covered quite a few already in previous stock reports.

• Defense: obviously the prime beneficiary of increased military spending. Military shipbuilding and simple weapon systems should come first (more cheap drones, less F-35s).

• Food & farming: people need to eat no matter what. Especially essential staple foods. Best if in a neutral country.

• Woodland & timber: trees will keep growing no matter what humans are doing. Timber will be precious for reconstruction at the end of the conflict.

• Gold: wars are the prime cause of inflation and money printing in history. Considering we are already struggling with too much money and inflation in peacetime, imagine what a global conflict could trigger.

  • Easier to flee with it than stock (capital control) or real estate as well.

    • NOT gold mining stock, as nationalizations are too likely to happen.

If this looks somewhat like the usual ZeroHedge / doomsday prepper portfolio, it’s because it is. That’s by design. But remember, this is just one side of the barbell.

So let’s get optimistic too…

The Offensive Part

This side is betting that we muddle through and enter a new golden age in a multi-polar, AI-driven, and energy-abundant world. This is a bet on the stocks that will be used throughout this time of crisis.

• China: Everything China, as the country in this scenario, avoids financial collapse or war. And its domination over the global supply chain has turned it into the dominant economy of the world it has been in 90% of human history.

  • Chinese Tech: partially because they are very cheap after the carnage of the 2020-2022 period. Maybe no need to get into picking winners and just go for Alibaba, Tencent, etc… After all, the same method of cheap tech giants worked great in the US markets in the 2000s and 2010s.

    • Some great innovators should be added as well. CATL comes to my mind, with mindblowing battery tech and control over more than 50% of the world's supply.

  • Chinese exporters, including car manufacturers, chip makers, electronics, etc…

• Emerging markets with plenty of potential but cheap valuation:

  • South America is a prime candidate.

  • South East Asia is another one, especially Indonesia.

• Energy: A growing world will need energy. A LOT of it, in any form.

  • Oil, gas, coal, nuclear. Take your pick.

  • All will be in high demand to fuel infrastructure in the developing world, more cars, more ships, more trains, more buildings, more space rockets, etc…

• Commodities: Besides energy, we will need more copper, lithium, iron, aluminum, steel (so coking coal), tin, zinc, silver, platinum, etc.

  • You can count on a growing demand for meat, fish, and protein in general as well.

  • Just staying away from cobalt and nickel, both at risk of new battery chemistry not needing them at all (check sodium and lithium iron phosphate batteries). If you are looking for battery metals, go for lithium or graphite.

• Picks and shovels: oligopoly or monopoly suppliers to growing industries will have strong growth + strong pricing power. Illumina in genomics, Transocean in offshore drillers, Unity 3D in digital assets, semiconductors manufacturing machines, etc.

  • The game here is to find rare assets hard to replicate, or unique technology, and a stellar track record on innovation.

• Keystone components: these are cheap, but important components of larger products. This gives a lot of pricing power to the company making them. Bonus points if in a growing industry.

  • Fragrances, colorants, speciality chemicals, carbide semiconductor for EVs, supplier to the space industry, etc.

It is worth insisting that in this category, stocks at the intersection of multiple categories will likely be the best pick.

Like for example South American energy producers or Chinese tech AND pick and shovel, like CATL. Or keystone components /ick & shovel for commodity production.

Proportion?

Should it be a 50-50 split between the 2 parts of the barrel?

In my opinion, no.

This is because a global conflict would trigger money to flee most equities in a panic, and more importantly, the bond markets (several times larger than the stock market) into what are currently very small sectors.

Remember, in the end, money always flows from one sector to another, but is rarely ”destroyed”. It just changes hands.

The top 5 of the defense industry in the US is valued at roughly $550B. The top 5 tech stocks are valued at almost 10 TRILLION.

20x more.

The gold market is a global 13 trillion. The global bond market is above 130 trillion.

10x more.

So as I see it, we should look at a 20-80 or 30-70 ratio between the defensive and offensive part.

The defensive part is likely to shoot x3-5 if the worst happens.

And if after all, everything turns out alright, the ultra-aggressive part should (hopefully) give 20%+ returns, carrying the whole portfolio above a very comfortable 16%+ yearly returns.

Prepare For A Roller Coaster

The downside of this strategy is likely extreme volatility. Long term returns might be good, but it will rattle your nerve on the way.

But this is anyway most likely going to be a feature of the 2020s no matter what.

After all, we are looking at simultaneous deglobalization, stagflation, great power conflicts, and an energy crisis.

So leverage is to be avoided as much as possible.

The exception might be for fixed rate debt with extremely long duration. If you are the manager of a corporation and still can get bond <4% fixed rate maturing post 2030, loading the balance sheet with them might be a good option to have cash to buy distressed assets and competitors.

Conclusion

A sign of intelligent and clear thinking about complex systems is the ability to hold 2 contradicting thoughts at the same time.

We are as likely to see energy or Chinese tech outperform, as we are at risk of global catastrophe.

Most people feel compelled to embrace ONE opinion and make it their directing worldview.

The best investors will embrace it all, and muscle up their portfolio with an appropriate barbell.