Lazard Australian Equity Team – Quarterly Letter FEB Letter from the Manager 2021 The Australian Equity Team’s quarterly letter discusses Exhibit 1 the biggest issues we are seeing in investment markets Long-Run Outperformance of Value Factor today. This quarter’s letter looks at: Excess Return Value Factor: 1825 - 2020 Fama-French: • Value drawdowns, economic crisis and reflation, 6 1927-2020 • How our portfolios are now positioned, and 4 Cowles: Goetzmann:SAE Active Weight (RHS) - Top Third • Our engagement with Mayne Pharma over 1871-1927 Excess Return 2 1825-1871 diversity in its board. 0 1. Value Drawdowns, Economic - Bottom Third Excess Return Crisis and Reflation -2 New long-term data suggests an important role for -4 1826 1856 1886 1916 1946 1976 2006 financial crises/debt overhangs in subsequent value As of 31 December 2020 drawdowns. Here we examine how past periods have Source: Two Centuries Investments ended and the striking similarities we see today. To this end, we view reflation as the most important topic in markets today. The global synchronisation of 195 Years of Data expansive fiscal programs may end one era and usher “The further backward you can look, the further forward you are likely in a new investment regime. to see” – Winston Churchill So far, the zero cost of money and liquidity of Drawing on US data from 1825 to 2020, it is now possible to the modern monetary theory (MMT) response to place the magnitude of today’s investment markets in a longer- COVID-19 has greatly increased trading, margin term context. In our view, there are interesting patterns between lending, speculation and frothiness on global stock economic events and style extremes, which are relevant to us today. markets. If the COVID-19 MMT spending does indeed lead to reflation and perhaps even inflation, the The Long Run Averages associated tightening of monetary conditions required may well lead to an abrupt end to market speculation. Exhibit 1 shows the full history that is now available, with a common definition of high third (“value”) vs low third (“growth”) dividend yield as the style factor employed across the full period. The additional historical record shows that the long-term outperformance of value has extended back close to 200 years, with The Data Prof Kenneth French’s data site at Dartmouth College provides detailed data on many markets and his US style return data commencing in 1926 is well known. A long time ago, Cowles1 had collected data on 1871 to 1926 returns and this has more recently been extended yet further back to 1825 by Prof William Goetzmann2 at Yale University and other researchers. Careful examination of price and dividend records from the NYSE has allowed these researchers to compile total return series and have made possible the calculation of value vs growth returns using dividend yield as the value factor. The data itself is available in raw form at Prof Goetzmann’s site at Yale University: https://som.yale.edu/faculty- research/our-centers-initiatives/international-center-finance/data/historical-newyork LR33518 2 the 3.3% pa long-short difference accumulating to greater than Exhibit 2 560x difference over the full period. Seen from this very long-term Value Drawdowns perspective, the record can appear like a relentless and inevitable (%) Value Factor Drawdowns: 1825 - 2020 win for equities priced on low expectations relative to growth 0 peers, but these very long averages hide much of the dynamics that are relevant to investors over five to ten year periods. -20 The Cycles Let us then focus on the drawdowns of value relative to growth, -40 which is shown in Exhibit 2. } Graham-Newman This longer-term history provides some context to the recent 1936 - 1956 20%/y 1841: 1862: 1904: 2020: -60 -50% -49% 1932: drawdown against value. In particular, it suggests that reversals -59% -54% -59% even of the magnitude of the current event may be a one in 40 1833 1863 1893 1923 1953 1983 2013 year outcomes (five times in ~200 years). As of 31 May 2020 Source: Two Century Investments The contrast between the drawdown graph, which shows value in drawdown 90% of the time and the vast cumulative gains is a great illustration of the contrast between the medium term and Debt overhangs may lead to low rates and government attempts long-term dynamics of markets – 90% of the time value was in to provide liquidity – cheap money is an important element in drawdown, but overall it recorded a relative gain of over 50,000%! speculative excesses. It may also be due to the fact that economic and policy extremes result in one-way trends for some years with Reversals from growth booms have often been completely less of the usual economic mean-reversion that usually characterises unexpected, very rapid and dramatic in their magnitudes across market economies – economies in post-crisis “secular stagnation” history, unfolding as an optimistic growth narrative collapses may be less competitive and dynamic. and high prices adjust, or as oversold markets rally sharply in a recovery. The Experience of 1890 to 1904 A connection between financial crisis The longest, deepest and most dramatic drawdown against value and growth stock booms was the 14 year period ending in 1904. There are some similarities between that era and our own recent past, and it is thus worthwhile A listing of the five great value drawdowns shown above (peaking to provide some historical background. in respectively 1841, 1862, 1904, 1932 and today) suggests The start of the value drawdown in 1890 was preceded by a an interesting possible connection between financial crises and financial crisis and the reintroduction of the gold standard in subsequent value drawdowns: the 1880s - and unfolded over the decade-long lingering 1890s • The 1841 drawdown of 50% was preceded by the crisis of “stagnation” (it wasn’t in the US a fully-fledged depression as it 1837, which left a legacy of debt and a decade of depressed was in Australia), just as the GFC marked the start of the current economic activity. value under-performance in the US and the so-called “secular stagnation” era. • The 1862 drawdown of 49% was preceded by the financial crisis and panic of 1857 and its legacy, and was probably also The 1890s depression was characterized by adebt overhang influenced by the early Union reversals in the unfolding US exacerbated by deflation driven by the slow growth of US gold Civil War. holdings – in the era of the gold standard, base money could only increase at the rate of gold accumulation and the rapid growth • The 54% drawdown of 1932 was due to the 1929 crash and of the US economy (industrialisation-driven productivity and resulting depression. population) exceeded this growth in the money supply. The • The longest lasting drawdown started in 1890 and culminated resulting deflation greatly worsened the impact of high debt levels in 1904 (and is expanded on further below). and led to increasing social tensions and economic inequality. What might be responsible for such an association - why Two bitterly fought presidential elections between the Democrats might value drawdowns tend to follow financial and economic led by William Jennings Bryan (famous for his “Cross of Gold” dislocation? While there is clearly not enough evidence to allow speech) and the Republicans led by McKinley, in 1896 and 1900 systematic analysis one might be tempted to suggest two possible both ended in wins for the status quo. While the Democrats causal links. lost the elections, they won the economic debate, however, and 3 after McKinley’s assassination, Republican Theodore “Teddy” Exhibit 3 Roosevelt’s second term was characterised by largely progressive US Excess Broad Money Growth policies. In addition, the 1899 gold strike in Alaska/Klondike eased deflation and the Witwatersrand, South Africa gold fields, (%) 30 which had only produced ca 50kt of gold per annum in the 1890s US Excess Broad Money Growth 25 increased production to 250kt pa by 1910. As a result, reflation (M2 Growth less Real GDP Growth - March 1960 to Dec 2020) characterised the second half of the 1910s. 20 15 The 1890s also saw the rise of many industrialmonopolies in the 10 US, including in tobacco (American Tobacco), steel (Carnegie’s US Steel), oil (Rockefeller’s Standard Oil), rail (Northern 5 Securities Company), sugar and meat-packing. President Teddy 0 Roosevelt acted against these, bringing 44 antitrust suits, breaking -5 up the Northern Securities Company, the largest railroad Apr-60 Aug-68 Dec-76 Apr-85 Aug-93 Dec-01 Apr-10 Aug-18 monopoly and regulating Standard Oil, the largest oil and refinery As of 31 December 2020 company (it was later broken up in 1911), amongst others. Source: Lazard Asset Management Long term interest rates fell over the 1890s depression and reached a 100 year low of 3.7% in 1900. Following the increase in the money supply, rates started to rise from 1900. Exhibit 4 Does Excess Money Drive Inflation? Average US Annual Excess Average Annual Similarities to Today Broad Money Growth US Inflation We see several similarities between the 1890-1904 and 2008-2020 Mar 1960 to June 1967 2.2% 1.6% periods, including a private debt overhang, markets dominated by July 1967 to Dec 1982* 6.3% 7.2% powerful monopolies, falling interest rates, disinflation/deflation Jan 1983 to Dec 2019 3.0% 2.7% and increasing inequality and social tensions. In the early 1900s Mar 1960 to Dec 2019 3.8% 3.7% these were overcome by increases in the money base and more Expected Year to Jan 27.5% progressive (including anti-trust) policies.