Smart Money Masters — July 2017 Issue

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Your Smart Money Masters portfolio continued its overall strong performance this month.

“Canada’s Warren Buffett” Prem Watsa’s long term bet on BlackBerry Limited (BBRY) rose 13.37% over the past month. Carl Icahn’s PayPal Holdings (PYPL) ended the month 5.65% higher as tech stocks continued to boom. Curmudgeonly Charlie Munger’s bet on Costco Wholesale Corporation (COST) gained another 5.13% and is proving to be the single big exception to the doom and gloom in the U.S retail sector.

Overall, your Smart Money Masters’ portfolio continues to show strong gains. Among your current positions, nearly all are profitable, and three are up by double-digit percentages. All recommendations are BUYS with the notable exception of Navigator Holdings (NVGS), which continues to suffer from the collapsing oil price.

In other news, activist investor Dan Loeb trimmed his holdings in last month’s recommendation, Baxter International (BAX), by 11.37% in the first quarter. The company remains Loeb’s biggest bet by far. Loeb’s Third Point LLC hedge fund still holds 46 million shares of Baxter and the stock accounts for a whopping 23.28% of Loeb’s publicly disclosed portfolio.

This past month has been all about rocketing tech stocks. Sure enough, both PayPal Holdings (PYPL) and BlackBerry Limited (BBRY) have been among your top performers.

Your slow and steady investments like Warren Buffett’s Berkshire Hathaway (BRK-B) and Markel Corp (MKL) tend to lag in bullish environments like what we’ve had for most of the past month. Nevertheless, you can expect these positions to resume their upward momentum when the market’s tone shifts to a more “risk off” mode.

Bridgewater’s Big Bet on Emerging Markets

This month’s Smart Money Masters recommendation — Vanguard FTSE Emerging Markets ETF (VWO) — is the top position of the quirky Ray Dalio and Bridgewater Associates, the world’s largest hedge fund. Dalio has been gradually increasing his already substantial bet on emerging markets. As of March 30, 2017, Dalio had built his cumulative emerging market position to an astonishing 58.14% of his $8.8 billion publicly disclosed investment portfolio.

Dalio has cobbled together his bet on emerging markets using a range of assets. As of first-quarter 2017, the Vanguard FTSE Emerging Markets ETF (VWO) constituted 32.5% of the portfolio. The iShares MSCI Emerging Markets ETF (EEM) comprised another 17.5%, while he invested 3.1% in the iShares Core MSCI Emerging Markets ETF (IEMG). Dalio’s emerging markets-related positions now also include the iShares MSCI Brazil Capped Index Fund (EWZ) and iShares MSCI South Korea Capped Index Fund(EWY). Both of these are now among his top six holdings.

The emerging markets sector is not a new investment for Dalio. Bridgewater has been investing heavily in emerging markets since Q4 of 2011 when its holding in that sector jumped from 15.8% of the portfolio to 32.7% in a single quarter.

Up until recently, Dalio’s bet on emerging markets has hindered Bridgewater’s returns. Since fourth-quarter 2011, the Vanguard FTSE Emerging Markets ETF (VWO) has generated a mere 21.10% return. In contrast, the S&P 500 index has risen by 90% over the same period.

The good news is that emerging markets appear to have bottomed over the past 12 months. Over the past year, VWO is up by 24.32% compared with a 17.06% gain in the S&P 500.

Investment Philosophy

Ray Dalio has a very particular investment philosophy. In fact, you could call both Dalio and his approach to investing downright eccentric. Bridgewater’s investment success over many decades makes this approach hard to ignore.

Dalio began writing down rules that would guide his investing in the early 1980s. He later amended these rules based on how well they predicted what actually happened. Bridgewater’s entire investment process is now computerized, as applies to the 100 or so liquid asset classes in which Bridgewater invests.

Bridgewater is best known for its “All Weather Fund” which uses Dalio’s concept of “risk parity.” In the All Weather Fund, Bridgewater invests in a diverse portfolio of stocks, bonds and other assets to generate positive returns in both good and bad markets. The fund has made similar returns to a 60% stock, 40% bond portfolio with reduced volatility.

More relevant to us is how Bridgewater generates market-beating returns for its “alpha” generating program, which has returned an average of 13% annually since its inception.

Our biggest clue comes from the quadrant Dalio uses to explain the drivers behind various asset classes in which Bridgewater  invests.

The quadrant model assumes that every asset class does well in certain environments and poorly in others. As the axes of the diagram show, the two primary forces that determine the economic environment are inflation and growth. When you combine these two drivers, you generate four possible states: decreasing inflation, decreasing growth; decreasing inflation, increasing growth; increasing inflation, decreasing growth; and increasing inflation, increasing growth.

According to the quadrant, bonds will perform best during times of slow inflation and slow growth; commodities during times of rising inflation and slow growth; and stocks will perform best during periods of growth.

Dalio’s Approach Includes Employing ‘Intellectual Navy SEALS’

Son of a jazz musician, Ray Dalio bought his first stock at the age of 12. Dalio went on to study finance at Long Island University and earned an MBA at Harvard in 1973. Two years later he founded Greenwich, Connecticut-based hedge fund Bridgewater Associates in a two-bedroom apartment.

Today, Bridgewater is the world’s largest hedge fund with more than $165 billion under management. It employs 1,500 people and has generated an average of 13% annual returns after fees. Former Fed Chairman Paul Volcker has said that Bridgewater Associates

has “a bigger staff, and produces more relevant statistics and analyses, than the Federal Reserve.”

Bridgewater surpassed George Soros’ Quantum fund for the title of most profitable hedge fund of all time in 2015, returning over $46 billion since its inception. In 2010 alone, Bridgewater’s returns were greater than the profits of Google, Amazon and Google combined.

Dalio is one of the more original thinkers in the hedge fund world. His firm is driven by a combination of his “principles” for life and the concept of “radical transparency.” The focus of his “principles” — which have been downloaded from Bridgewater’s website over 2 million times — is to pursue truth at all costs. Bridgewater’s culture of “radical transparency” prohibits gossip and encourages employees to air their grievances in public. Dalio describes his employees as “intellectual Navy SEALs.”

Personally, Dalio is a quirky guy. On the one hand, Dalio is proud to admit he’s done transcendental meditation since 1969. On the other, a former personal assistant for Ray Dalio described the experience as similar to working for Glen Close’s character in the movie “The Devil Wears Prada.”

It is hard to argue with Dalio’s financial success. Forbes magazine ranks Dalio as the 84th richest person in the world. He ranked ninth on the Forbes 2016 list of Highest Earning Hedge Fund Managers by earning an estimated $500 million in 2015. He also has signed the Bill Gates and Warren Buffett-backed Giving Pledge, a promise made by some of the world’s richest people to give away at least half of their wealth to charity.

Dalio stepped down as co-CEO of Bridgewater in April, but remains at Bridgewater as a co-chief investment officer and co-chairman.

Dalio’s Model of the ‘Economic Machine’

Dalio also has developed a unique macroeconomic framework which guides his decision-making process. He discusses this model in some detail

in a video called “How the Economic Machine Works” that has garnered well over 4 million YouTube views.

Paul Volcker, a former chairman of the Federal Reserve, has described this economic model as “not very orthodox but it gives (Dalio) a pretty good sense of where the economy is.”

Dalio models the economy from the bottom up. He argues that conventional economics does not pay enough attention to the individual components of supply and demand. To understand demand properly, you must know whether it is funded by the buyers’ own money or by credit.

Dalio also emphasizes the roles of two cycles in the economy: the business cycle, which typically lasts five to eight years, and a long-term debt cycle, which can last 50-70 years. A business cycle usually ends in a recession, because the central bank raises the interest rate, reducing borrowing and demand. Business cycles happen often and they are well understood by policymakers. In contrast, a debt cycle comes along once in a lifetime, which is why they are poorly understood.

An ordinary recession ends by the central bank lowering the interest rate again. In  contrast, a long-term debt cycle deleveraging requires a combination of debt restructurings and write-offs,  austerity,  wealth  transfers  from rich to poor and money-printing. A “beautiful deleveraging” is one in which all of these  elements combine to keep the economy growing at a nominal rate that is higher than the nominal interest rate.

Dalio argues that the world today is at the very end of a longer 70-year deleveraging cycle but not just in the United States. Since 2008, the world has added over 50 trillion dollars of new debt, compounding the previous  problems.

One thing is certain: Central banks will continue devaluing fiat currencies to keep the global economy afloat. That’s because they have run out of ammunition and can’t drop interest rates any lower to induce spending. Still, over the near-term, Dalio sees “no major economic risks on the horizon for the next year or two.”

Dalio’s Case for Investing in Emerging Markets

Dalio views his significant bet on emerging markets in the context of the quadrant framework for investing and his “Economy as a Machine” model.

In terms of the quadrant, Dalio’s expected scenario is for growth and inflation, which is why he is overweight emerging markets. From the standpoint of the “Economy as a Machine” model, Dalio sees the following.

First, productivity in emerging markets has continued to improve while it has stagnated in developed market counterparts. Annual growth rate in real GDP per capita in emerging markets measured since 1970 stands at 2.4%. Over the last 10 years, that rate of growth in productivity has increased to 2.6%. Meanwhile, productivity growth has been slowing and, in some cases, even receding, across much of the developed world.

Second, once you take China out of the equation, emerging markets as a whole are less indebted than the United States and the rest of the developed world. Developing nations are less constrained by the burden of deleveraging that weighs heavily on growth in Western economies.

Finally, today’s economic growth rates of 4.1% in emerging markets outstrip the developed world’s relatively stagnant rate of 1.9%. Compound that difference out over time, and it makes an enormous difference to investment returns.

More conventionally, Dalio sees several factors are converging to support emerging market stocks.

These include a weakening U.S. dollar, improving corporate fundamentals in emerging markets, relatively attractive valuations and a “reversion to the mean” of emerging market returns after an extended period of underperformance.

A growing number of investors are coming around to Dalio’s view. Coming into June,  EPFR Global-tracked Emerging Markets Equity Funds posted their 11th consecutive week of inflows, extending its longest run since a 23-week streak ended in the first quarter of 2013. Many short term investors have been attracted by strong recent gains in emerging markets, with the Vanguard FTSE Emerging Markets ETF (VWO) rising 14.29% year to date compared to 8.51% for the S&P 500.

So buy the Vanguard FTSE Emerging Markets ETF (VWO) today, and place your stop at $30. I’ve given this recommendation a medium risk rating of 3.

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