Dan Rasmussen of Verdad Capital did the Ted Seides “Capital Allocators” podcast recently, and talked about the fact that we know very little about how to predict the onset of a recession. However, we do have very consistent information about what investments have worked best on the way out of a recession once it’s begun.
This was so good I did the transcript by hand. I had to stop walking up Sixth Avenue and listen just to make sure I didn’t miss anything…
What should you buy during a crisis?
We spent about a year and a half doing this research. We looked back at the last eight recessions, which we define as when high yield spreads rise above six. That’s mostly in-line with the definition of a recession but there are two or three things that that picks up like the 2016event that wouldn’t be caught as a formal recession and there are a few things that are formal recessions that don’t really affect markets for whatever reason. And then we said, okay, if you look at three months after spreads hit six, so you’re right in the thick of things, what should you have bought? What should you have bought in bonds? What should you have bought in stock? What should you have bought by asset class? And one of the things we had found, and there were a few overwhelmingly interesting things, the first is that returns are more predictable in times of crisis than they are outside of times of crisis. In fact, simple quantitative models tend to have eight times the level of statistical power during recessions than during times of economic growth.
Why is this the case?
In times of easy money, a lot of stupid things work. A lot of unprofitable companies see massive increase in stock price. A lot of bad ideas get funded, some of those bad ideas turn out to be good ideas. And that’s surprising. And so a lot of simple valuation models, or simple quant models, don’t really work all that well in times of great growth or easy money.
However, when a recession comes, all external funding gets cut off. All the venture money shuts off, all the new private credit money shuts off, all the bond money shuts off, all the bank money shuts off, there’s no external financing.
So the people that survive are the people that have profitable businesses that generate cashflow. And the people that don’t survive are the idiots who would otherwise, maybe in a good market, do well. And so what you see is that simple value models if you control for hey, let’s look for profitable companies, turns out profitable companies that are bought in times of recession to much better than unprofitable. Companies that generate free cash flow do much better coming out of a recession than companies that don’t. And, what’s most interesting is that buying cheap and illiquid companies does massively better. So if you go into the market and say, I’m going to take advantage of this recession by buying small companies, where the stock price has just gotten puked out because people are panicking, but it’s profitable and cash flow-generative, but it’s so cheap and it’s illiquid, which means that the small change of the market was down five, this thing is so illiquid it went down ten that day – you go and buy that stuff, your returns coming out of the recession are extremely attractive.
Josh here – a tilt toward the small (size) and value factors, even with a profitability or “quality” overlay hasn’t done you any favors over the last decade. But that’s precisely why it could be the right place to be in the next ten years.
Dan’s entire appearance on the episode is an absolute tour de force of knowledge and useful information. I highly recommend listening to the whole thing when you can.
You can also watch Dan talk with Barry and Michael on our YouTube channel about the hidden dangers of Private Equity, whole video below!