Buying the Unloved
Being a long term investor requires not only a great deal of patience, but the emotional control to buy investments that offer long term growth potential when prices are depressed. Most investors are incapable of buying an investment when the price is low because that often means that their investment portfolio may not grow in line with what markets might be doing short term. Emotionally, most investors can not reconcile the long term value of their investments with the short term prices.
Today is such a time for many investors. Due to massive government intervention many stock markets have moved up the past year. The United States S&P 500 is up 10.2% (through March 4, 2011) since the opening of 2010. Many people's accounts are not up inline with that performance. Because of this, people become emotional and worry more about missing a few percentage points of gains, than the level of risk that they should be taking or what the long term outlook is for their holdings. This is a dangerous time for many investors because they are prone to making bad decisions.
In the spring of 2007 I mentioned to a room full of investors that the financial markets were on perilous ground. Specifically I said, "Wall Street is not on your side." Looking back, I can see that the people who were there that night came to understand what I meant as events unfolded in 2008 and 2009. Because I took a cautious approach then our losses in 2008 were far less than the broader market losses.
In early 2009 I began to move back into more invested positions in the stock markets and as a result caught the large early part of the current cyclical bull market. However, by the end of 2009 I was largely in a market neutral position again, simply waiting to see how things would unfold. I took multi-billionaire and Berkshire Hathaway partner Charlie Munger's approach:
“We just throw some decisions into the 'too hard' file and go onto others.”
As a result, we missed some of the upside in 2010.
Why did I take that approach. Simply put, we are still in the midst of a long term downward trend in equity markets and appear to be near the end of the bull market in bonds. Government intervention, in my mind, is clearly responsible for stabilizing economies and driving markets up short term. At some point, governments have to spend less and print less money. When that happens, equity markets will be in trouble again.
As I have said recently at investor meetings and in letters, although I think the world is slowly improving economically, there are huge headwinds blowing, in particular massive demographic issues. In the United States we have to pay for the baby boomer retirement. In China, the labor force is aging causing wage inflation. In Europe entitlements are overwhelming entire nations. In Japan the population is aging disrupting the labor market.
The great hope to offset the demographic issues in some of the very large economies is for emerging markets to grow. By virtue of their still small relative sizes, that hope is slow to occur. Make no mistake, emerging markets will largely drive the world economy for decades, as we have discussed ad nauseam, however, they will not carry the world economy anytime soon.
Today, there are few opportunities that offer the upside potential with mitigated risk that middle class investors need. Save for a few interesting spots.
Buying the Unloved
That brings us to our title. What out there is priced in a way to offer strong returns over the next few years without taking on outsize risk?
In general I would say Chinese equities among equity classes. Over the past two years Chinese equities have largely lagged. Prices on many Chinese companies are ripe with potential. Growth in China will continue at a high rate for a very long time. The risk we have to be aware of are accounting problems and outright fraud with some of these companies. Investing in China requires precautions. For example, we strongly favor companies that use a Big 4 auditor and have a significant institutional investor already on board. We also use a pair of managers with extensive on the ground knowledge of China. Recently we have taken more Chinese positions and I foresee taking more over the next year or so.
Natural resource investing gets a lot of attention because of the run those companies have been on recently and the uptrend in the prices of food, gold and oil. Many of the companies that benefit from rising commodity prices have already risen by double the past year. Most are fairly valued or over valued. We have taken a position in an exchange traded fund that invests directly in commodities, rather than in stocks, and is formulated in a way that compensates for difficulties with investing in futures markets.
We see some value and a margin of safety right now in some natural gas holdings, junior miners and drillers, and alternative energy. We have a holding in two companies that are leveraged to growth in the solar markets. I expect I will take a broader position in alternative energy using an exchange traded fund on any broad price pull back or on significant momentum upward.
There is also bio-tech. Bio-tech offers some of the biggest potential opportunities today, not only because the break-throughs are exciting for the impact to our lives, but because many bio-tech break-throughs lead to a decrease in the cost of health care- something the government desperately wants to see. Many bio-techs have trailed the markets for years despite scientific advances and products moving towards market. That trend can not continue indefinitely. Our largest stock holding is in a bio-tech company located in Madison and I expect to take more bio-tech positions over time.
Your forward looking advisor,