Sunday, March 11, 2012

Is the Market Afraid of Secular Change?

Are you as tired as I am of hearing that the stock market is cheap based on history? That is like saying that if I pay attention to my rear view mirror, or in some cases rear view camera, I won’t have an accident, except if I drive into something or someone ahead of me. Why are the potential buyers not jumping into these “relatively” cheap prices? Perhaps, the buyers remain un-invested because they sense that prices do not reflect enough of a discount to future values. Compared with historical precedents, future prices won’t be as high as expected. Or, perhaps they are saying to themselves that they are uncertain as to what future prices will be.

Playing the cycle

Normally after a period of economic decline or slowdown, market prices accelerate in an upward trend. The appropriate way to play this game is to invest with managers who find that current prices do not reflect current values, and in more extreme cases, there are deep value managers that believe that stocks are priced below their current acquisition values for knowledgeable strategic buyers. Often their portfolios contain ways to play industrials and/or industrial commodities and materials. These kinds of strategies have worked well since the bottom of the current major upsurge some four years ago. As an analyst of the mutual fund business as well as a portfolio manager of portfolios of funds and other financial services investments, my judgment is that the performance is good, but not good enough. Not good enough to get massive flows into these funds. I wonder why? This lack of enthusiasm has lasted long enough for me to begin to believe that there is an analytical underpinning, and not that every long term fund investor has been seduced into buying an exchange traded fund (ETF).

The long-term

Historically, managers’ of pools of capital, (their own or for other people and organizations) make current decisions with the belief that they can make quasi-permanent investments that won’t have to be changed. In other words, they hope they can see the future clearly enough to be considered sound and perhaps wise investors. They believe not only that the current price is appropriate for today’s conditions, but it is at a significant discount to future prices. Their beliefs are based on the visibility of long-term secular trends. The absence of these trends may be what is holding them back, with all of their potential equity capital.

In John Mauldin's March 5th blog (free subscription required), a very thoughtful piece by Niall Ferguson is published which outlines the advantages that Western Europe and (therefore the US) had over the rest of the world, starting about 1500, just as China was turning inward and losing its position as the most advanced and richest society. Briefly the six advantages he lists are:

  • Competition makes people and groups focused and stronger.

  • Scientific revolution with its breakthroughs in mathematics, astronomy, physics, chemistry, and biology, generated Nobel Prize winners benefitting the countries they came from.

  • The rule of law and representative government are essential requirements to keep the competitive or animalistic tendencies honest.

  • Modern Medicine gave us more productive lives.

  • The Consumer Society demanded more, better and cheaper goods. I would add safer products and services.

  • Work Ethic combines more extensive and intensive labor with higher savings rates, thus sustaining capital accumulation.

These attributes, characteristic in the last generation, are now being found elsewhere, largely in Asia. Japan, in its own way developed solutions to become, for awhile, the second largest economy and a generator of technological consumer goods, including cars that were in demand throughout the world. Looking at the above listed factors, there are two major concerns for those who are looking to jump on board the secular trends that led to American Exceptionalism. First, in almost every case we are losing or have already lost our leadership position with possible greater relative losses coming. For example, students in both Singapore and Shanghai score higher on math tests than those in the US. Koreans have a 220 day school year vs. the theoretical 180 day teaching schedule in the US.

My second concern is that the speed of advance on what were considered unassailable positions is dramatically accelerating. The following is a list of collapses largely due to internal pressure and economic, often deficit spending, problems:

  • The Roman Empire suffered losses and deterioration over a thousand years, however the real collapse occurred in one generation.

  • Though advanced in many areas, the Ming Dynasty collapsed in a short period of years. The current government is very conscious of this history.

  • The Soviet Union fell apart due to its attempt to keep military and space spending up to the levels of the US.

  • In the “Arab Spring,” three Northern African regimes fell in a matter of months.

These kinds of unexpected changes suggest investors not use long periods to develop their valuation processes. We all know that an 8% compound growth rate will create a doubling in nine years. But what if you don’t believe that you can see eight or more years into the future? Around the world, 2012 is the year of elections and other changes in government leadership. Facing all investors is the guess as to whether the next government, if it is a continuation of the present regime, will have major differences in policies than ones present today. Under these circumstances one can understand that investors are reducing the length of future discount periods. Even if one thought that earnings, net cash flows, or dividends would rise 20% in the next twelve months, it would produce a lower return than the doubling over nine years. On that basis, a lower than historically normal price/earnings ratio seems warranted. This calculation explains the lower valuation that is present in today’s market and thus for the non-buyers, the market is not cheap!

Are there positive secular changes?

For something to be a secular change that can be relied on, it will have to be long lasting, easy to recognize and cause tectonic shifts in the global economy. Allow me to suggest three major changes that can be described under three classifications: wear out, dine out, and dry out.

Wear Out

As an urban society we have become dependent upon the use of housing, transportation, power and household appliances. In the US, China and much of the English-speaking world, we built more living quarters than immediately needed. Many of these stand vacant for lots of reasons, including the fact that their construction techniques are leading to faster “wear out” phases. As we have been creating family units faster than new homes being constructed, we will see a pickup in the reduction of the overhead supply and there will be some additional houses built. This turnaround appears to be occurring ahead of a major economic turnaround because of another “wear out” set of factors. Young people want their independence and their parents want their own freedom. Both sets are wearing out their welcome. Both may contribute to the departure of the younger generation. The second set of “wear out” drivers is the physical and technological obsolescence of electrical power systems, and the need to replace cars and appliances that are too expensive to repair. While the manufacturers have long calculated scrap page rates, the need on an individual level comes as a surprise. (This week, we had to replace our refrigerator and a washer and dryer with foreign brands.) Regardless of economic conditions, these “essentials” will need to be replaced when no longer serviceable.

Eat out

Both China and India already have larger middle classes than the US. One of the characteristics of urban populations is that they can no longer gather their food from local agriculture and must rely on stores and some form of restaurant to provide their meals. (A recent Wall Street Journal article about a mining town in Russia that is having economic pressure, has two McDonald’s in it.) One impact of the change in location to cities is that people’s diets on average now use some 3420 calories per day, compared to the 2630 calories when they were living rurally. For speed and energy needs, the diet uses more meat/chicken protein. This growth is requiring China and others to import grains to feed to their animals. Only from Argentina, Australia, Russia, and the US can they get the quantity and quality what they need.

From an investment standpoint, long term portfolios may need to have farm land as an alternative. For those of us who choose a secondary approach, buying into companies or local banks that supply goods and services (including capital) to farmers, could be attractive. There is still another way to benefit from this trend, which is to get into the transaction stream of agricultural futures. My preference, which I have done, is through a provider of agricultural future funds.

Dry Out

China has approximately 20% of the world’s population, with an obvious need to feed its people. Unfortunately, it has only 6% of the world’s fresh water, which has not been well managed for years. While I do not know of any funds that specialize in water-related equipment and services stocks, there are numerous companies and parts of companies working in this area.

Investment Conclusions

I suggest that a wise investor might look at today’s lack of future visibility and thus a low valuation period, as an opportunity. Instead of being fearful of oncoming secular changes, be opportunistic and focus on one or more favorable secular trends.

Please let me know if you believe I am all wet.

Did you miss Mike Lipper’s Blog last week? Click here to read.

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