Introduction
If you listen to most red-blooded Republican candidates for President, you will often hear lists of U.S. virtues that are claimed to be superior to all others. There is never any attempt to prove the assertions – they are articles of faith. And, as we saw in last quarter's letter, the claims are mostly inaccurate and by a wide margin. Indeed, in this one respect Mr. Trump is far more accurate when he suggests that the U.S. has fallen off the pace in recent decades and has done much better in the past and could perhaps do much better again.
But this quarter I would like to examine two areas where the U.S. really does have documentable advantages. They are both incredibly important, one especially for good times with thriving capitalism and the other as a protection against possible bad times in the future that I for one fear.
1. Animal spirits and venture capital
In a world in which most things continue to work well, or at least well enough, the U.S. has the advantage of simply being more entrepreneurial. More of us risk starting new enterprises than do others in developed countries. Keynes famously made the point that almost no one, looking at the 10% survival rate of new enterprises, would take the risk in cold blood.1 He argued that the recklessness brought by a surge of animal spirits was necessary to lead entrepreneurs to believe that they would be the exceptions. And Americans apparently have more animal spirits than most. In the U.S., much more than in Europe and elsewhere, it is also okay to have failed. Some visible scars are taken as proof that you have played the game hard. Our culture is more forgiving. You can even be associated with several bankruptcies and still be a strong-running candidate for President! How unlikely that would be anywhere else. And if three times more of us charge at the Internet, medical research, or social enterprises than in other countries, then we do not have to be better. The laws of averages will guarantee, given even average competence, that when the smoke of battle clears we will have more of the Amazons, Facebooks, and Coca-Colas, for that matter, than they do. And we might indeed be a little better. Over half of the world’s top 100 brands are American, even though we are only 20% of the world’s GDP, and that ratio has been looking strong in the last 20 years as new great brands appear. Seven of the strongest seventeen global brands2 have their U.S. founders still living, without including Apple, the number one brand, as a sad near miss. What a remarkable testimonial to the recent vigor of American entrepreneurial spirit this is. Last quarter I talked about
the downside of overconfidence and accepting only good news. Well, this is the upside to what can often seem like excessive optimism: We undertake far more than our fair share of substantial start-ups and we dominate the formation of great new global brands.
Not surprisingly, perhaps given our inclination for risk-taking, we have also ended up with by far the biggest and, I suspect, the best venture capital industry. In this we represent almost half the dollar value of all global venture capital invested in a year (see Exhibit 1). This industry in turn has the unfair advantage of feeding off the world’s great research universities. In this regard it is, like most areas of life these days, a winner-take-all environment. Among universities, Harvard and Stanford are not associated with twice the money raised for start-ups than the twentieth largest money-raiser, but 10 times more.3 Last quarter, I talked about the relatively average quality of the typical U.S. student. That fact does not take away from the nearly complete dominance by the U.S. of the top-rated academic universities globally. In the 3 rankings that I checked, the U.S. had 15 or 16 entries out of 20 in all 3 (the U.K. had 3).4
This is not meant to ignore the importance of governmental R&D, which has declined as a percentage of government spending over recent decades. Increases in R&D would feed into the strengths we already have in the three areas of natural risk-taking, venture capital dominance, and the great research universities. It would also come at a time when we are faced by greater non-military threats than ever before: climate change and the need for alternative energy technology.
Our strong position in new enterprise has, I think, important investment implications for today. I believe the returns to cash and bonds are certain: They are certain to be low or negative. Global equity markets in the developed world are overpriced, particularly in the U.S. In the developed world, real estate and even farms and forestry all yield 2% or so below their long-term averages. I believe that these miserable potential returns have been brought to us courtesy of the Greenspan-Bernanke-Yellen Fed regime and their belief in interfering in markets, manipulating if you will, and their moral hazard asymmetry. This is a long and old story and I will just resist going into it one more time.
In stark contrast to dismal returns in investable public markets is the continued high return on equity available to corporate investing, the mean-reverting series that refuses to mean revert, where
competition no longer serves, apparently, to bring returns back to the old averages. We can argue about the reasons for this. I lean to the Andrew Smithers line that it is caused by the “stock option culture” in which stock is bought back – this last year a record $800 billion – and deals are made, also at record levels, rather than capacity expansion, which has run at mediocre levels. But whatever the reasons and despite a modest decline in margins in 2015, caused mainly by oil and mining wipeouts, abnormally high returns at the corporate level are a fact. This persistent discrepancy – that in theory is arbitrageable but in practice apparently is not – between low returns to private investors and high returns to corporate investments suggests an investment strategy: Get as close to corporate investing as you can. The closest is to start your own company. Failing that, the next nearest is early-stage venture capital where the investor gets some of the benefits, small or large depending on the circumstances, of the entrepreneurs. Another way of looking at this is that reduced capital spending by established public corporations leaves more opportunities for new start-ups (and for private companies).
GMO’s 7-year forecasts, which are based on margins and P/Es returning to a longer-term average, suggest that returns on public investments will range from negative to about 3% (with the interesting and risky-looking exception of emerging market equities, which now offer a more normal 4% return as shown in Exhibit 2). Even if U.S. corporations did not regress in either margins or P/E, the current modest yield and modest growth would offer less than 4% a year on our forecasting methodology. In contrast, corporate return on equity, after adjustments for some wonky accounting that has gotten steadily more suspicious over the last 25 years, appears to be considerably higher than its old 7% real, perhaps as high as 8% to 10% real. You can see what a handsome gap there is. A gap that has existed now for almost 20 years, although on average smaller than it is currently. Its lengthy stay, in defiance of theory, owes a lot to the Fed and a lot to the new corporate fixation on short- and intermediate-term profits. While it lasts, diversified venture capital offers, I believe, the best investment opportunities. Adding to the case for venture capital is that over the long run it has had a higher return than have public equities, a rare case where theory coincides with reality, for venture capital is perceived as the higher risk asset and should in theory have a higher return.5 In the interest of full disclosure, the Grantham Foundation is aiming at over 30% in venture capital, putting its money where its mouth is (or, more accurately, where my pen is). At this point it is appropriate to point out the illiquidity and risk of venture capital. Why can’t we just have a free lunch? Investing in venture capital obviously requires experience, skill, and extreme diversification and should not be attempted at home.
Finally, on this issue, venture capital represents one of the best opportunities for “mission-driven” or “impact” investments. By investing in alternative energy projects and agricultural research and improvements the Grantham Foundation is offered at least the hope of handsome returns together with the certainty that we are helping our two most critical global needs. So, from these several perspectives it is good to be based in the U.S. and particularly in Boston, a city that, along with the San Francisco Bay area, best represents this greatest relative strength of the U.S. in global capitalism.
2. Fortress Canamerica
The problem of feeding 10 billion humans is likely, I believe, to create increasing problems. Soil erosion, desertification, and other land degradation deprive us of over 30 million acres a year. Urbanization costs us some more. It has been calculated that after over 12,000 years of farming, done sometimes very badly and sometimes merely suboptimally, 5 billion of our original 16 billion acres of useful arable land has become unusable. And now destabilized weather, especially extreme droughts and floods, cost us increasing percentages of our soil through erosion and increased crop losses, which have risen from a 5% average annual loss 30 years ago to 15% today6 in the developed world. This and other reasons have caused our net gains in productivity to drop from over 3% a year in the Green Revolution of the 1950s and 1960s to just over 1% now and the trend profile is for further declines in productivity gains.7
These difficulties, though, are very unevenly distributed. Africa and the Middle East drew the short straws. The Americas drew the long straws, and everyone else, as a broad generalization, is in the middle. As you know from my previous quarterlies, I am extremely worried about Africa, which is estimated to have all of the world’s future population growth, coupled with a long list of agricultural problems: the worst soils on average and the greatest soil degradation; the worst availability of surface water distribution; poor access to energy and fertilizer; the worst food distribution system, a terrible infrastructure, and, on average, the poorest governance. It seems likely to me that they will receive insufficient effective assistance to meet their challenges. Their neighboring Middle Eastern countries share many of the same problems. The odds favor the continued increase in these two areas in the number of failed states, a process that has been going on for the last several years. That in turn threatens, indeed almost guarantees, an increasing wave of immigrants or refugees into Europe that will inevitably stress some of the component countries into severe economic or political problems. Unless we are extremely lucky, these destabilizing forces – climate and food problems together with refugees and other immigrants – will unsettle global politics and create repeated crises, which will be made worse by terrorism. Not a pretty picture and one that increasingly concerns the minds of various military and intelligence groups including our own.
In this rather nightmarish potential it is clear who has the best hand to play: the U.S. and Canada (and, to a lesser degree, South America). The list of our advantages in Canamerica, as we could call it, is a very long one. First, we are uniquely defensible and difficult to attack. We are well-armed and well-organized. Less obviously, perhaps, we are more than self-sufficient in food production, energy, and mineable resources. Exhibit 3 shows how we rank in water and arable land per capita. We have six or seven times more of these critical resources per capita than China or India. We have two and a half times the available ratios for the rest of the world.8 To rub in our advantages in arable land, we are much over-represented in the highest-quality loess soils – those that come only from accumulations of wind-blown soils over millennia and are found in quantity only in California and the Midwest, Argentina, Eastern Europe, and Northern China. These soils are often tens of feet thick and so productive that you can get a reasonable harvest after your top soil has blown away, when less fortunate populations would starve. We have enough reserves of fossil fuels that if we put our best foot forward we can convert successfully to renewables. Even given the wasteful “big ag” we have today we are only deficient in phosphorus looking out beyond 50 years and we have sufficient reserves of fertilizers to buy us time to change our agriculture to more sustainable practices. (On phosphorus, we have to make sure that after the next decade or two we stay friendly with Morocco, which controls ±75% of the world’s high-grade phosphorus reserves, as regular readers know.) We have a sufficiency of basic metals and most of the more exotic ones. We could, if necessary, finesse those few we lack.
These are not small advantages. No other area of the world comes close to having our assets. I have extreme doubts that densely populated countries even in the developed world could feed themselves in a highly stressed global world. But even in such a world, Canamerica, almost uniquely, could probably sustain up to twice its current population – although strongly not advocated! This, together with the first point on animal spirits, is the true American advantage, not the ridiculous and provably wrong ones we hear on television. On most of those alleged virtues we are merely average among developed countries and on most of them we have been slipping. On some, like income inequality, health, and social cohesion, we are at or close to the bottom of the list.9 But on the two aspects featured here, both extremely important and one certainly the most important factor of all, we are truly fortunate and, yes, exceptional.
