The Master Game

In my youth I played chess. I wasnt bad, but no prodigy and I lacked the fanatical dedication
to ever be very good. I did learn a lot about trading from playing chess, however. When we
played at school the traditional stake was a Mars bar and sometimes the cash strapped loser
would go for a double or quits rematch. The pressure of those two Mars bar games would
affect players ability to think clearly I noticed. I also learned a lot about compounding. Doubling
down could be risky-my epic 37 game winning streak against Phillip Upton meant in Game 38
some 69 billion Mars bars were on the line. He won that game and never played me again,
having achieved the classic loss making investors dream of getting out even.
Chess is struggling today, young people have a vast number of brilliantly constructed
electronic games to seduce them, and chess programmes are so good now that even a
modest one can trounce any Grandmaster. This demotion to second place by computers is
something we must get used to, its going to carry on until we are second best at everything;
in many forms of trading it may already be here.
But back in the 1970s chess players were the nerds rock stars and a brilliant BBC TV
programme called The Master Game allowed you to watch some of the greatest players
contend whilst an audio track voice over of their thoughts explained why they were making
their moves.
The most thrilling matches were when one of the favourites was put on the rack by an
unexpected move. What to do? What to do now? I am only playing for a draw The Czech
Grandmaster Vlastimil Hort agonised in his thick middle European accent- this was as exciting
as television got in 1976.
It would be a wonderful thing if we could hear the thoughts of central bankers and pension
fund managers today as they plan their next move in the
true Master Game of the global economy. The last quarter
has put them all under pressure and solutions using
traditional approaches seem unlikely.
In the late medieval story of Doctor Faustus, the ambitious
doctor seals a pact with the devil in which he is given twenty
four years of supernatural powers in return for his soul at
the end of the term. Quantitative Easing has given pension
fund and endowment managers a Mephistophelean
bargain, with marvellous capital appreciation over the last
six years; but the Faustian pact comes with a terrible
downside and we are facing it now. In essence this all
comes down to the beauty and terror of positive or negative
compounding that Phillip Upton faced in his double or quits
chess losing streak.

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Compounding and retirement

To illustrate the nature of the problem facing the financial world in Q4 2015, lets look at what
lies ahead for investors if these conditions persist
If we take a very simplified model for a single pension fund contributor who starts contributing
to his pension at 24 and retires at 65 and pays in $1,000 each year, his total contributions to
his pension are a modest $41,000 over his lifetime of work. If his pension fund is able to
produce an 8% return over his working life the miracle of compounding produces a pension of
$282,519 on retirement; and if there is an 8% return to still be had, that produces an annual
income of $22,601p.a.
If his fund manages a 10% annual return his lump sum leaps to $492,378 and his retirement
income soars to $49,238 p.a. Small differences in compounding rates have major impacts.
These impressive returns have, in some form, been enjoyed by some post war retirees buoyed
by strong returns and huge compounding. Inflation has certainly eroded the spending power
of those returns but nevertheless many privately run post war pension funds have managed
that 8-10% in our model and produced comfortable retirements for their contributors.
Compounding in a Post 2008 world
The post 2008 financial world has been a changed landscape. The risk free rate was cut to
negative as a Zero Interest Rate Policy was imposed on the world to try to prevent a financial
crisis turning into a global economic crisis. Whether this was wise or not is moot, it is an
historical fact and the effects have been significant. The annual return on the S&P 500 Jan 1
2009-Dec31 2014 has, with dividends, been around 17%; bonds have done pretty well too
with an average total return post 2009 around 4.6% p.a. So a blended 50% equity, 50% bond
fund in the US should have produced a return of around 10.8% which is excellent. The problem
with these total returns however, has been in the composition. Far too much has come from
capital gain and not enough has come from income-- from dividends and coupons. Capital
gain is a great thing and every trader and investor aspires to it daily. However, for asset
classes broadly, capital gain is bringing forward tomorrows income; consuming it is
consuming the seed corn of future harvests. Bond funds have been reporting returns
materially higher than yields since the financial crisis; this is a game that was always finite but
as we have had an ongoing bond market rally for almost all of the last 30 years; it always
seemed possible there was more gain to be had. Even when Swiss bonds, and long dated
ones at that, were producing negative yields, some pundits were still recommending holding
them on the grounds that yields would go yet more negative and produce gains for the holders.
This is as close to madness as bond markets can go and is a complete perversion on the
whole rationale of buying bonds as an investment. As of writing Swiss 10 year bonds have
yield of -0.24% guaranteeing the long term holder a loss of 2.4% when maturing in 2025. It is
plain logic that over the long term a bond fund, on average, cannot produce a return in excess
of its yield.

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Government Maturity Yield

USA
10
2.04%
Spain
10
1.81%
UK
10
1.80%
Italy
10
1.67%
France
10
0.94%
Germany
10
0.57%
Japan
10
0.32%
Switzerland
10
-0.24%
Mean
10
1.11%
Which in an (improbable) equal weighted portfolio would be a yield of 1.11%. These yields are
so unattractive as a direct consequence of crowding out due to QE. No rational investor would
choose to own them for the long term as an investment
But the situation in equities, whilst better, is problematic too. Yields are better in almost every
major market than in the bond market but as investors in companies such as BHP, BP and
VW can all attest, equity dividend yields can fall as well as rise. Even after the falls in 2015
value in mature stock markets looks scarce

Market
S&P500
Spanish Ibex
UK FTSE
Italian MIB
French CAC
German DAX
Japan TOPIX
Swiss SMI
Mean

PE

Yield
17
17.5
22
17.5
19.4
15
15
17.4
17.6

2.25%
6.00%
4.30%
3.00%
3.40%
3.10%
1.80%
3.40%
3.41%

Which produces a simple average of a PE of 17.6, and a dividend yield of 3.41%. None of this
is very constructive if you are an allocator allowed to choose only between cash, which yields
nothing, equities, which are expensive and bonds which have the lowest yields and are the
most expensive in the history of capitalism. For example, there has been some very erudite
investigative work trying to work out whether German bond yields are the lowest since the
Thirty Years War (1618-1648); or the Black Death (1348-1350). Either way, they are very, very
low.

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Investing your way to poverty

Now if we revisit our hypothetical 24 year old embarking on a lifetime of pension fund
contributions we see the catastrophic effects of these low yielding stocks and bonds.
If we take an optimistic scenario that the pension fund stays 100% invested in equities and
achieves the full P/E expressed as a yield, so 17.6X= 5.7% This leaves our worker with a
pension of $153k at retirement and an annual income, at 5.7% of $8,720 p.a. And this is the
best case.
If his pension fund is 50% bonds, 50% stocks the yield falls to 3.42%, a pension of $87k and
a retirement income of $2,975 p.a.
If his pension fund decides to go for safety and invests 100% in the debt of the 8 sovereign
nations above, at an average 1.07%, his pension after 41 years of labour would be $52k, and
his retirement income would be $593 p.a. Which would place him, and all his generation, in a
perilous state for their dotage.
And this retirement catastrophe isnt some mathematical straw man of our own devising. We
keep a hawk like eye on US TIPS (Treasury Inflation Protected Securities) that pay out a
coupon of CPI + X; that X being, effectively the real return on capital after the corrosive effects
of inflation. The 30 Year TIP currently yields 1.2%, so that final, catastrophic result of a pension
barely compounding over the lifetime of the worker and placing him in penury at retirement is
not such an extreme scenario, it is potentially a real one.
However you calculate it, compounding matters hugely and QE, whilst it has pushed asset
prices up in the short term, has left most capital markets with no return prospects for the long
term.
In a recent thought piece Deutsche Bank looked at bonds and stocks in 15 countries back to
1800 (and Real Estate back to only 1970) and calculated that bonds have only been more
expensive for 17% of the past 215 years; and equities 23%. Real Estate, interestingly, was
right in the middle of 45 year valuations, more on that later. The Economist featured the piece
under the title

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Many Unhappy Returns

Optimists will argue this is too bleak because growth and innovation will allow equities to
gradually grow to deliver much better returns over time. I am one such optimist, but there are
a few caveats facing us over the next few years:
Headwinds for listed stocks
Firstly, corporate profits are very high already. US corporate profits as a % of GDP are pretty
much at a 70 year high; any mean reversion in this trend would be very painful indeed for
profits.
Secondly, far too much of post 2008 mature market corporate profitability has been driven by
bottom line efficiency gains, rather than top line growth. The S&P 500 will experience a mere
2.1% revenue growth in 2015 according to the usually overly optimistic analyst community.
Profit growth from cost saving and efficiency is admirable and private business managers have
shown an extraordinary ability to continue to squeeze the lemon long after many thought it
impossible. However, this bottom line efficiency has some negative macro-economic effects.
Delayed business investment, is good for the bottom line, but one mans efficiency is anothers

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lost revenue. Similarly the negligible wage gains for the average worker in the US since 2008
has been great for costs, but has robbed the consumer and the recovery of vigour.
Thirdly, corporates in mature markets have been able to supplement slower growth at home
with faster growth in overseas markets. But in Q4 2015 robust growth anywhere on the planet
is hard to find, the IMF have reduced their global growth forecast for 2015 to a mere 3.3%,
once considered trend growth for the most mature of markets.
So a combination of all time high profits as a % of GDP, overreliance of bottom line efficiency
to drive those profits and a global growth drought will all be making organic growth for stocks
a significant challenge in the near future.
So, if we could, Master Game style, listen in to Janet Yellens thoughts as she ponders her
next move
The inner thoughts of a Central Banker?
Zero rates for 7 years now. Id really like to raise them just a little, but, whats really going on
in China? Well, theres no sign of inflation and no hint of wage inflation, clearly with this
participation rate were not near NAIRU even at 5.1% unemployment. So no rate move in
September, markets have been a bit weak, Ill put out a dovish statement to help (next
move) What? markets hated that dovish statement; Ill put out a slightly more hawkish
statement
But none of this gets us any closer to the Fed winning this game, which would be defined as
both growth and inflation; (and presumably interest rates) being back within acceptable and
comfortable norms. We also get a strong sense that the Central Bankers of the world now
realise that QE has created some short term benefits to the holders of capital, but with some
long term consequences which could be catastrophic. And if the choices available to central
bankers are increasingly limited, for pension fund managers with traditional liquid capital
instruments only available to him; the situation is much worse.
For if we could listen in to the interior monologue of a senior pension fund manager it would
surely be even more concerned.
The inner thoughts of a pension fund manager?
What to do now? Where do I move? Its been an awful year; stocks are horrible, mature
markets weak, emerging markets ghastly; even my tech and biotech stars are off; that
diversification into commodities has been a disaster; and the fall in equities hasnt produced
the normal increase in value for bonds. So what to do? How am I going to get that 8%
compounding p.a. weve been promising? Equities arent looking so hot any more, but if I get
out now and buy more bonds Im just locking in losses; bonds dont look able to make those
losses back, and how do I get to 8% p.a. with my bond portfolio yielding 2.5%? Can I keep
this game going until my retirement?

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So the great stock and bond inflation looks like it is entering and endgame with a very grim
outcome for future retirees.

However, all is not lost we believe. To quote Grandmaster Vlastimil Hort on Master Game
again I dont like the way the board is looking, so Iet us change the pieces. Rather than
Holts series of lightning piece exchanges, investors can change the pieces by breaking out of
the mental prison of stocks, bond and cash which have done so well in the past 35 years,
and look elsewhere if they want to beat the inevitable unhappy returns to come.

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With one leap, he was free

We have been investors in Agricultural land since 2009. Initially we were drawn to it as a safe
store of value and inflation hedge but it has also shown strong yield characteristics. When we
first bought in the corn belt of the Mid-West in 2009 the land was earning 7% in rent. This was
attractive when added to the possible increase in inflation. However, as it turned out, food
prices, and many other commodity prices did not inflate. What did inflate however was the
price of the land; which we sold in 2014 for a 65% profit. The profit came about, not because
the rental income had risen, nor that the food produced had become more valuable; but simply
because by 2014 yield compression meant that a 4.25% yield was seen as attractive. Which,
compared to a 10 year TIPS at 0.53%, it is. If the owner can get a 3.75% capital appreciation
he is back within reach of the magical 8%, and unlike a bond, land should be inflation proof.
We sold the corn land to focus on horticulture because we see yields as being significantly
higher over time. Our pilot avocado and kiwi fruit orchard in New Zealand has given us volatile
returns due to weather and fruit price fluctuations but this year it will yield over 20%; and my
neighbours say they are averaging 13-14% cash yield over decades from their orchards.
Despite the volatility we see this as extremely attractive, especially as we see good prospects
for long term price appreciation for fruit like avocados and Kiwi

Productive agricultural land was the cornerstone of endowment funds for monasteries, great
estates and academic colleges for centuries. Indeed it was said that in 1800 a man could walk
from St Johns College Oxford to St Johns College Cambridge without leaving the land owned

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by them both. As an investment it fell out of favour in the 19th Century as the vast lands of the
US interior opened up and drove wheat prices ever lower; but it should, once again, be in
every long term portfolio as it will almost certainly outperform bonds over the next 20 years
and have superior yield along the way.
One of the drawbacks of agriculture in the current environment is that as an asset it does not
suit leverage well. This has been understood for a long time
Heres a farmer that hanged himself on the expectation of plenty. Cries the drunken porter
in Shakespeares Macbeth. And many farmers have both figuratively, and tragically literally,
hanged themselves on a bank debt inconsistent with the volatile nature of returns from an
enterprise at constant risk from the elements.

The greatest problem facing any investor or custodian of wealth today is that financial
repression, most explicitly in the form of Quantitative Easing, has reduced the value of money
and capital by making the Risk Free Rate negative. But this great challenge can be turned to
great advantage if this wealth invests in the equity portion of an asset that can access cheap
debt. And we believe we have found a very good one indeed.
We should say explicitly that as a family office backed investment house we have an innate
dislike and distrust of debt. Indeed, the volatility caused by the collapse of asset prices in 2008
caused by leveraged forced sellers flooding markets, made Artradis Barracuda and AB2 funds,
the $5bn long volatility hedge funds we ran between 2002-2011,a massive fortune. So the
absence of debt and the ability to buy low, sell high which is not available to the leveraged
investor, has yielded us the greatest returns.
However, to everything there is a season and this is the season of financial repression. The
extremely low interest rates that come with financial repression create opportunities to use
debt to build wealth. Over the past six years we have built a real estate business in Germany
that now employs 18 people and manages over 1,800 apartments. We believe that German
real estate remains at bargain prices, although as we saw in the Deutsche Bank thought piece
quoted above, it is, on average, generally the least over-priced asset class globally.
Although there have been some significant price rises, and associated yield compression in
the real estate of central Berlin, Munich and Hamburg; much of the German real estate market
continues to offer excellent value with gross rent yields of 8-10% readily available. Even with
the significant costs of maintenance, rent collection and local taxes a net yield of 5.25-7% to
the investor looks sustainable. Given we think German real estate is cheap, and relative to
both incomes and rents there is ample evidence to support this; this looks quite attractive,
especially as Real estate should be an excellent hedge against long term inflation.

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Whilst this looks attractive on a non-leveraged basis, leverage changes the picture. Germany
has an anomalous interest rate environment. Normally an economy with a robust economy
has an interest environment higher than those with a weaker economy. Due to the European
currency union this doesnt hold. Within the Euro group the strongest economies have the
lowest interest rates, the weakest, the highest, so not only are German interest rates low
because worldwide interest rates are low, and due to a weak overall economy European
interest rates are the amongst the lowest in the world; but Germany has the lowest interest
rates in Europe because its economy and fiscal soundness are the best.

So, German banks are keen to lend to good quality, tenanted residential properties because
deposits at the ECB are yielding negative rates and Germany is a generally lowly leveraged
society. At present
We can get 7 year fixed debt from German banks at 1.6-1.8% on 70-75% of the value and
cost of the property. This transforms the net yield from an acceptable 6% unlevered yield to
an extremely attractive 18.6%; even before the possibility for capital gain is included. In
practise the business of running and maintaining real estate means that that 18.6% falls to an
achievable 11-12%; but that is more than enough to beat the financial repression and as an
at least modest increase in value is all but certain wed be disappointed if our German Real
Estate wasnt returning us 20% p.a. over the next decade. Now, obviously the leverage comes
with some heightened risk, but as the property investment vehicles are non -recourse it is the

Page 10

bank lender who is really bearing the bulk of the risk and so we have turned the weapon of
financial repression away from us to give us, the investor the advantage.
These sorts of solutions to the Yield Problem do have the major disadvantage of being illiquid
and that is a real consideration. However, well run endowment and pension funds are
supposed to have a clear idea of the long term liability matching which they exist to do, so
whilst a cash reserve of liquid assets would always be prudent, its hard to see how that safety
amount would ever exceed 10-15% of assets.
Liquidity is a nice thing to have, and usually better than illiquidity (although some make an
argument that a long term commitment when enforced produces better returns); but when the
price of liquidity is investment failure; as we would see the whole sovereign bond market, it is
a crutch that must be foregone.
We expect our medium and long term returns on our unlevered orchards to be in excess of
15%, and our levered German Real Estate returns to be in excess of 20%. Many private equity
fund managers would not be impressed by that, some of the best PE funds have track records
much better than that (in a good vintage). But critically 85% of those orchard returns and 75%
of the real estate returns are produced by yield, not capital gain, and that for us is a vital
difference. Some highly austere efficient markets theory followers would claim that a rational
investor should be indifferent between capital gain and yield, but as a practitioner is has been
my experience that yield is backed by an effectively performing investment, whereas capital
gain is backed by someone elses money and the strength of their animal spirits. When
planning for a retirement I know which one I would rather rely on.
And if our theoretical 24 year old were to get the returns we are expecting from our agricultural
and real estate investments his retirement prospects would truly be transformed.

Type of instrument
Annual payment Years paid Compounding Lump sum at retirement
Annual income in retirement
Tradional pre 2000 pension
$1,000
41
8.00%
$282,519
$22,602
Post 2015 equity
$1,000
41
5.70%
$153,274
$8,737
50/50 Equity & bonds post 2015
$1,000
41
3.42%
$86,972
$2,974
Sovereign bonds post 2015
$1,000
41
1.11%
$51,583
$573
Orchards
$1,000
41
15.00%
$2,087,133
$313,070
German Real estate
$1,000
41
20.00%
$9,107,584
$1,821,517

In the real world no-one will have a pension fund comprising of one alternative asset, but the
returns above are not fictional. We believe they are distinctly possible both for the pension
disaster of traditional assets and the transformational impact of high yielding alternatives. Wed
go further to say that it is almost inevitable that the coming crisis in retirement will lead pension
funds of the near future into many more alternative assets, agriculture and real estate included.

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The winners of this Master Game will win a great deal more than the 2,500 the BBC was
offering the greatest chess players on earth in 1976. And if that prize seems laughably small
39 years later, that should also be another warning of the corrosive effects of inflation over
time.
Your move.

Steve Diggle, Founder, Vulpes Investment Management Private Limited

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