Sunday, November 18, 2012

After Selling Short-Term, You Should Buy Long-Term

Two weeks ago I suggested that on a trading and cyclical basis one should sell on the Wednesday after the 2012 US election. My thinking was based on the premise that the election would not provide a meaningful answer to the economic future of the US or to the rest of the world. Since the election, on average six out of eight market sessions have recorded losses. This continues the trend for the last four weeks since the probabilities that the president would be elected rose, and the market average declined 5.66%.

What did the US election signify?

As this blog is increasingly being read by those who are not Americans, I should share with you my analysis of the election.  (Readers from over 40 countries have joined our blog community.)  In general, Americans have had a fear of government actions unless they are directly helped, and often vote by selecting the least objectionable candidate. This election was decided upon the basis of perceived personalities. There was no real focus on a perceived future. Despite the victor’s view, there was no policy mandate given, as only a little over half of the potential voters voted and the spread in the popular vote was less than 3%. However, there were at least two clear implications that will affect the next election cycle that began on November 7th. The first is that the Chicago machine is well trained in urban get out the vote campaigns and produced a much better result than the Boston-oriented management consultants who thought they were dealing with a corporate turnaround. The significance of this disparity is that winning politics is not just policy, but performance. The second implication for the Republicans is that they need to select better candidates for the House and Senate. (Interesting enough, the Republicans were more successful in terms of races for governors, other state officers and state legislatures.)

Fiscal cliff or barrier mountains?

Those who want short and complete answers to complex problems speak in terms of a single fiscal cliff.  I see the challenge as a series of difficult to solve barriers to a free floating economy. The basic problem (which is not being discussed in the US and most other major countries) is that the governments are providing services to a population that is unwilling to commit to pay the bill. This is not a new phenomenon in the US. Alexander Hamilton, the first Secretary of the Treasury bemoaned this very same condition. In Hamilton’s 1795 report to the Congress, he described the public’s desire for services, and their unwillingness to pay for them through higher taxes. The answer was to borrow the shortfall. However, as much as he tried, at the time Congress was unwilling to establish a specific plan to extinguish the debt. Today we have the same problem. We are facing the threat of sequestration, which will automatically raise tax rates and cut both military and discretionary spending. In addition to sequestration there is the self-imposed debt limit, which will likely result in a credit rating drop. On Friday there was a happy talk session at the White House where the congressional leadership appeared in public to accept some broad but not defined principles of cooperation.  Believing that “God is in the details,” I have my doubts that we will see any meaningful solutions until we get a final House-Senate conference committee proposal. The earliest that I expect any sort of practical compromise will be in March and maybe not even then. The timing may be ironic, as in March the new leadership of China will be in command to somewhat more aggressively manage the world’s second largest economy.
Disclosure:  Not only did Hamilton and I graduate from the same college, he founded the bank where I gained my first fulltime employment on Wall Street.

As much as the politicians might want to be able to act in their own time, there may well be external pressures that will change the picture of cooperation substantially. The first pressure will be the probable need to restock the Cabinet with replacements that will have to go through what could be rough interrogations from the Senate minority party. The second force, dear readers are you, the investors. The bond market can no longer play its traditional role as bond vigilantes because of the manipulation of the credit markets by various governments. Replacing the bond market in its role as protector will be the stock market. If both individual and corporate leaders sell because they feel that their taxes will go up too much for them, there will be a negative “wealth effect.” If the general population feels that they will be poorer due to higher taxes, they may seriously restrict their spending. This could deepen the recession that the Congressional Budget Office (CBO) expects in the first half of 2013. International actions and other surprises could also change the arduous progress to various agreements. Moody’s is predicting that corporate default rates will rise from their abnormally low levels, moving back to their historically more normal ranges. Let us hope that a relatively minor increase in defaults won’t lead to a rise in unemployment, which could impact any congressional compromise.

Secular bulls:  your time is coming

As an optimist, (as is everyone who gets out of bed in the morning), I am concerned about the relative lack of other optimists; as a contrarian this absence makes me bullish. If one believes in secular trends as I do, you may see that we are setting up one of the great bull markets of our lifetimes, not in magnitude, but in length. PIMCO, the world’s largest bond manager believes that stocks will outperform bonds in the future, but the average rate of gain will be more like 5% than the historic 10%. While they may be correct in terms of the aggregate growth of operating earnings, I see a good chance that stock prices will be higher than earnings projections due to valuation adjustments. Beyond that, I believe that there are a number of opportunities to do materially better than the market. There are two very different examples as to how this can happen.

The global label

Even if the US solves its fiscal problem, the odds are that its standard of living will decline relative to other parts of the world. Work ethic, education and demographics trends are moving against the US. In recognition of this, I believe that US investors need to invest their equity in a portfolio that has at least 50% of its underlying earnings power from non-US sources. This can be accomplished by investing 60% of the equity portfolio in US multinational companies. These companies have at least 40% of their own earnings from overseas sources. They can accomplish this by having overseas production sites selling into local markets; e.g., Coca Cola, Colgate, etc., or by exports (net of imports) like Boeing and Deere or a hybrid like Apple,  whose annuity-like future I believe is in making and selling products in China. (Though I have used large company names, there are any number of mid-sized or smaller companies that would qualify particularly in terms of exports and royalties.)  The multinational portion of the equity portfolio would have foreign earnings of approximately 24% (60% x 40%  = 24%).  In addition to the 60% in US multinationals, an additional 21% of the equity portfolio should be invested in local companies overseas, particularly those that do not have much of their sales in the US.  Thus 60% + 21% = 81%, which will leave 19% for purely domestic investments. I have presumed that you or your adviser has the requisite knowledge not only to do the detailed analysis of foreign vs. US content, but to also pick winning stocks. If your level of comfort in these abilities is not high, then perhaps some or all of this strategy can be well executed through the use of mutual funds or similar vehicles.

Disruptive Opportunities

I search for companies that perceive opportunities differently than others. Everyone’s favorite example of this is Apple, but this was not a good example years ago when I got some shares. Allow me to use a very narrow example from my particular area of focus, the financial services industry. In a private fund that I manage for a few clients and my family, we own 22 financial services company stocks. Since I learned securities analysis initially under Professor David Dodd, of Graham and Dodd fame, I believe that any and all companies can be acquired. Currently the brokerage/investment banking business is having difficulties. In the last couple of weeks KBW (Keefe, Bruyette & Woods), a dominant financial services broker, is being acquired by a larger more diversified firm. This week ICAP, a UK interdealer firm has closed its New York floor operation and announced significantly down earnings. The general perception is that these businesses are having a rough time and could be terminally sick. This week there was the announced disruptive acquisition of Jefferies, a position in our portfolio, by Leucadia National. In the future, the combined company will be managed by the senior people from Jefferies and they will be able to use both Leucadia’s capital and net operating loss carry forward. What is significant to me about this deal is that as a result of this merger, the new company will be managed for the growth in its book value not its quarterly earnings. This approach is similar to two of our other holdings, Berkshire Hathaway and Alleghany Corp. Actually what has me excited is that I perceive this deal as creating the US equivalent of the very successful (for awhile), UK Merchant Banks. While the US rules are now different than the set of rules that operated in the UK, some of the activities could be similar. To the extent that all of the perceived advantages of this combination come to be, it will change the acquisition of turnarounds in terms of competition with private equity groups.

I am reasonably confident that these types of transformational deals will occur in many sectors of the economy and will create highly focused special opportunities.

It’s your turn

Now it’s your turn to share with me how you are structuring your portfolio.
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