- There are many examples of simple investments that returned more than 1,000%, some even 10,000%, over the last few decades.
- In order to take advantage of such investments, you have to look at the extremes of what could happen in the next few years that aren’t included in the current economic models that use statistical averages.
- Statistical averages are what you have to look for to protect you from negative surprises and open your portfolio to extremely positive surprises.
A friend of mine just sold his home in Central London for 2.4 million pounds which is an average price in London. However, what’s interesting is that he bought the property in 1996 for just 160,000 pounds. In just 20 years, the value of his London property increased 15 times.
Another example I have is from a recent WSJ article where a Park Avenue penthouse is selling for about $18 million. The funny thing is that the property was empty for 27 years as it was owned by the Former Republic of Yugoslavia which also allows us to know what the purchase price was in 1975. The purchase price was $100,000. In 40 years, the value of this property in New York increased 180 times.
Similarly, the U.S. stock market has increased 25 times over the last 35 years.
These are very important things to think about because in this quickly changing world, it’s necessary to have an investing mindset that allows you to seek such extreme returns.
The funny thing is that buying real estate in New York or London back then, or stocks in 1982 at a PE ratio of below 10, seems like a low risk thing to do.
Today, I’ll first discuss a bit more the extreme environment we live in and then discuss some sectors where it could be smart to invest now as they offer the possibility of extreme returns in the future.
Extremistan vs. Mediocristan
The concepts of extremistan and mediocristan were introduced by Nasim Taleb in his book The Black Swan where he elaborates on the fact that this world has always been skewed toward the extreme. This is important for investors because most of the data used for analysis discusses averages, but those averages used to calculate portfolio risk, expected returns, etc., are composed of extreme inputs—like real estate prices in London or New York, or the rest of the world where many places have seen prices remain almost flat or below inflation—giving the appearance that everything evolves in a stable manner.
But the truth is far more complicated than what average statistics try to show us. If we take a look at FRED’s housing price index form 1980, the index “only” went up 7 times, not 180 times as has been the case for the New York property discussed above.
Similarly, UK home prices increased, on average, 3.5 times in the last 20 years, not 16 times as properties in London did. This means that many real estate prices haven’t gone up at all in the last 20 years.
This all goes to show that it’s extremely important to position yourself in investments that have the opportunity to grow at an extreme in the next 20 years while leaving the average to average investors and the below average to those who just look at what’s cheap forgetting that things are usually cheap for a reason.
To conclude on extremistan investments, Taleb explains that it’s wrong to use averages to measure all things because what makes an average is so variegate that many things will exceed what we’ve prepared for, both on the upside and downside. Consequently, if we are in the domain of extremistan, and we use analytical tools from mediocristan for prediction, risk management, etc., we can face enormous surprises. Some of these surprises may be positive and some may be negative, but their impact will likely exceed what we are prepared for.
Let’s now define extreme investments in order to have our portfolios surprise on the positive as much as possible.
Defining Extreme Investments
The things extreme investments have in common is limited supply and expected stability.
On the limited supply side, you can’t significantly increase the number of New York penthouses nor the number of cozy Central London Victorian houses. So we have to look for investments where the demand will outpace supply while the supply is relatively fixed.
Given the global expansive monetary policies, we can continue to expect a constant increase in the supply of money which makes price explosions like the ones we described at the beginning of this article even more likely to happen in the future.
On the expected stability end, no one expects a drop of 50% of more in the S&P 500 at this point, so buying out of the money put options is an extreme investment that could lead to a nice payoff.
Investments With Probable Negative Surprises
In my article on bonds from last week, I described how the outlook is extremely risky especially if we see higher interest rates coming from higher inflation rates.
The fact is that many look at the risk of bonds from the perspective of what has happened in the last 35 years when interest rates have only declined making bonds very vulnerable to negative extreme surprises. If we see interest rates suddenly climb to 10% because some central bank around the world loses control over its money supply or people lose confidence in their currencies, we could see a quick spike in interest rates and consequently doom and gloom on bond markets. So bonds are definitely in for a negative extreme surprise in the next decade.
If we see a similar situation to the one from 1950 to 1982, where interest rates were constantly rising, the situation will be even worse. Remember, 99.9% of investors use recent stable models to calculate the risk for bonds, just 0.01% of investors look beyond the last few quarters.
One who does look beyond what has happened in the last few quarters is Ray Dalio.
Investments With Probable Positive Surprises
I see positive extreme surprises in the resources environment.
Modern technology is available globally which means that soon, all of the technological perks that we enjoy in the developed world will soon expand to the less developed parts of the world. This means that there will be a huge surge in demand for certain resources that have limited supplies.
Just think of oil prices a few years ago. Back in 2008, a Goldman Sachs analyst predicted oil prices at $200. Oil prices didn’t reach that level due to technological disruptions, but it shows how extreme the move in resource prices can be.
Now, the world is switching to electric power and leaving fossil fuels behind. This means there will be more need for the metals closely related to electric energy production, renewables, and batteries. I’ve already discussed nickel here, and copper here, so today I want to show you what could happen to nickel and copper miners if the respective metal prices enter extremistan territory which is very likely as decarbonization will favor those metals to the extreme.
Current copper prices are at $3.16, but look at the surge from 2004 to 2008 when copper prices went from below $1 to almost $4 per pound. This was due to extreme growth in China and stable demand from other parts of the world. What we have coming in the next decade is the fast development of other parts of Asia, namely India, rapid urbanization due to middle class explosion, and a global boom in demand for electric solutions primarily from vehicles and other kinds of transportation. The Warren Center think tank in Sydney estimates copper demand to more than double based on the above trends with total expected demand being above 50 million tons where the current supply is around 23 million tons.
As copper supply is extremely limited due to declining ore grades and limited investments, with current low copper prices, I wouldn’t be surprised if we see a similar spike in copper prices like the one seen from 2004 to 2008. If I take the starting point of $2 per pound in 2016, the top would see copper at $8 in a few years.
Let’s see what would prices of $8 per pound mean to the largest copper focused miner, Freeport McMoran (NYSE: FCX).
FCX produces 3.9 billion pounds of copper per year, and each $0.1 per pound increase in copper prices adds $275 million to their operating cash flows as their mining costs are relatively fixed. If copper prices surge to around $8, FCX’s operating cash flow would surge by $9 billion in one year, not counting the additional cash flows coming from a potential increase in production.
I know operating cash flows of $13 billion sound crazy ($9 + current $4), but that’s exactly the extremistan kind of investments people should be exposed to. At such cash flow levels, I wouldn’t exclude a valuation of at least 15 which leads to a market capitalization of $180 billion, or just short of 10 times the current market cap.
(Note: This is a back of the napkin calculation as FCX has some issues with the Indonesian government that could lower its ownership stake by 40% in its flagship Grasber mine, but this shows the potential copper miners offer. Also, the free cash flows could be much higher.)
The nice thing is that FCX doesn’t look like as bad of an investment now as its trailing free cash flow is above $2 billion which is ok for a $21 billion company, but the cash flows should be even better as copper prices have really spiked in the last few months. This gives you a relatively low risk investment that offers extreme upside potential.
Keep reading Investiv Daily to be regularly exposed to interesting investing ideas with high potential and low risk. After all, it’s all about the investing mindset, and nothing else.