AIM13 Commentary - 2024 Q2
People are often surprised when something terrible happens in the world or in the markets even though there were plenty of warning signs in advance. Unfortunately, too often people choose to ignore or downplay indications that there is trouble brewing. For example, in the decade leading up to 9/11, there were many signs that our enemies were planning something terrible against us. Just to name a few, these include the 1993 bombing of World Trade Center, Bin Laden declaring war on the US in 1996, the 1998 African embassy bombings, and the 2000 attack on the USS Cole which were all precursors of what happened in 2001. Warning signs like these by their nature are often overlooked or not viewed as portents of things to come. However, to paraphrase Joseph Heller, just because something isn’t screaming something terrible is coming does not mean that something terrible isn’t coming.
We see a lot of this happening today. While we may be accused of being a doomsayer or Chicken Little, we think pretending everything is fine is a mistake. We think there are enormous risks out there, and in today’s world you really have two choices: (1) live in a bunker; or (2) take steps to reduce risk. We choose the latter – in our lives, with our families, and when it comes to investing. We view our job is to generate superior returns but the only way to do that is to determine how much risk we are comfortable with and then monitor it so that we stay within that risk band.
Where do we see risk today?
On the surface, even with the volatility in early August, overall this year things appear generally fine in the markets. Year to date through today, we have had 42 record closes for the S&P 500 TR, and since October 2023, the S&P 500 TR has had only two drawdowns of 5% or more. Even the most recent pullback from mid-July to early August was “only” about -8.45% and since then the markets have largely recouped those losses. We think, however, that there is much more trouble brewing than most people are ready to accept.
In our last quarter letter, we said we will proceed with caution in today’s environment. Since then, we have had a near assassination of presidential candidate, a sitting president announcing he was stepping aside, a retaliatory attack on Iran by one of our closest allies, and one of the biggest one-day drops ever in equity markets around the world. Were we wrong then to say proceed with caution or are we wrong now to focus on risk? We do not think so. Focusing on risk yet proceeding with caution means that you take steps to mitigate the chances of something going wrong.
We think investors are not adequately factoring in the risks we see. There are things less visible than those recent dramatic events mentioned above but that equally (or even more so) deserve our attention:
Infiltration at the border: As reported by CNN, on June 11th, eight Tajik nationals with ties to the Islamic State were arrested in New York, Los Angeles, and Philadelphia. The group entered the southern border illegally, and concerns were immediately raised that they might be planning an attack similar to the brutal killing of 139 people at a Moscow concert hall in March by four Tajik nationals. We have said before that the vast majority of people coming through our border are simply seeking a better life. However, our concern is that without adequate controls, it just takes one person with a more sinister motivation to cause us unspeakable harm.
Growing national debt: Since just the early 2000’s the national debt has increased almost six-fold, reaching a level that is almost impossible to comprehend. Why does it trouble us so much? For one, debt service prevents spending on other things. For instance, in 2023 alone, the U.S. spent more on interest than it did on Medicaid and income security programs. Huge debt also reduces the flexibility to respond to tail-risk events like the Great Financial Crisis and the pandemic.
National Debt By Year: A Bipartisan Problem
The unfortunate reality is that our ballooning national debt leaves our children with a burden that can only lead to harsh austerity measures or, God forbid, default and possibly civil war.
Fentanyl crisis: According to the US Drug Enforcement Administration, fentanyl is now the leading cause of death for Americans between the ages of 18 and 45. As reported recently in The Economist, every 14 months or so, the U.S. loses more people to fentanyl than it has lost in all of its wars combined since WW II, from Korea through Afghanistan. And it just gets worse every year: In 2023, the DEA seized more than 77 million fentanyl pills and nearly 12,000 pounds of fentanyl powder. This is the most fentanyl seized by DEA in a single year and amounts to more than 386 million deadly doses of fentanyl, which is enough to kill every American.
How do we mitigate risk in our personal lives?
Like a lot of people, we take common steps to reduce risk in our personal lives like buying insurance, eating healthy and exercising, and maintaining our “situational awareness” when we are in less safe places. Unlike a lot of people, however, we think we do a few things that go beyond “normal” risk protection in our personal lives, some of which include:
Maintaining adequate cash in a safe place at home.
Storing emergency bags at work, in the car, and at home.
Keeping defibrillators accessible at home and at work.
Freezing our credit, both for ourselves and our children.
Having emergency evacuation kits (rappel cables) at our office and home to escape from buildings.
Readers of our letters also know we spend a lot of time on cybersecurity, investing in the space and trying to stay on top of one of the most rapidly evolving threats to personal and corporate security. At the end of this letter, we have included a list of all of the private cybersecurity companies that we have invested in alongside our managers in our private equity program. While not an endorsement per se, these are the firms that smart managers are backing financially and often using themselves for protection.
How do we mitigate risk in our investments?
Like we do in our personal lives, we take the common steps that most investors take to mitigate the risk of loss in our investments, such as maintaining a balanced portfolio with adequate levels of cash and diversified across managers, sectors, asset classes, stages, etc. We also spend a lot of time with our managers analyzing their portfolio risk management, including position concentration levels, liquidity, “crowded trade” risks, and exposures. Unlike many investors, however, to avoid losses coming from areas outside what is typical, we look at things we think some others overlook:
Reputational risk and the importance of avoiding managers who do not share our values.
Integrity and the importance of “do what you say, and say what you do.”
Momentum risk where one outperforming investment exceeds portfolio risk limits.
Re-underwriting current investments and avoiding the bias towards incumbents.
“Selling winners, buying losers” where the original investment thesis or price target hasn’t changed.
Business risk and a manager’s controls against cyber attacks, fraud, or operational losses.
The use of leverage to enhance returns but also magnifying the risk of loss.
Catastrophic risk contagion across the portfolio due to such things as terrorism, wars, or pandemics.
Unlike a lot of people, we are constantly asking ourselves, what could go wrong? And then we work to minimize the chance of that happening and the negative consequences of missing a risk when we choose to invest. While it is a lot more fun to ignore risk, fun is not our objective. Yes, we enjoy what we do. Everyday, we are looking at interesting investment opportunities, spending time with smart and accomplished investors and company founders, and generating returns on our investments for our own capital and that of our partners. However, above all, we are fiduciaries, of our own money and that of our family’s, and of our partners. As such, we must focus on the downside and where we see risk, and take steps to mitigate its consequences.
We welcome any questions or thoughts you may have.
Sincerely,
Alternative Investment Management, LLC (AIM13)