Saturday, December 26, 2009

Investment Outlook 2010 - Inflation Resistant Stocks

2009 was an eventful year as the financial crisis played itself out, and the stock market plunged in March as panic set in. Investors who bought during panic are now enjoying a nice lift as the S&P 500 looks set to close the year at about 1100, a large rebound from its March lows of around 700.

However what is remarkable is that even during the lows in March, stocks were never truly cheap by historical standards, nor were they really cheap from a Discounted Earnings perspective. (See the October 2008 post for my view of stock valuation). Value fund managers like John Hussman have alluded to this, and investment managers like Jeremy Grantham have placed the S&P 500's fair value at around 900. Whichever the case, today's 1,100 level puts stock squarely in over-priced territory.

I believe the odds are that the overall market will become cheaper over the next few years, simply because history suggests that after bouts of overvaluation, investors tend to allow markets to spend many years in undervalued territory. Assets prices are determined by what people are willing to pay for them, and human psychology has not changed over the last thousand years. There is no reason to believe that this time is any different. But this doesn't mean that prices will fall to once a century lows, because the democratization of investing and the raised awareness of stocks since the 1960s.

There are many ways the market can revert to cheaper levels, for example: (a) the market trades sideways over the next few years between 700 and 1000 while earnings continue to grow, or (b) another correction occurs in 2010, possibly triggered by a financial panic or the realization that slow economic growth is here to stay.

The future is inherently unpredictable

Of course one knows for sure if these outcomes are going to play out. Both markets and the economy are complex systems which are hard to predict. They also rely on individual decisions made by human beings that are driven by their own psychology and life experience, and reactions to each other. This makes it difficult (or some would say impossible) to use economic data points to predict the behavior of the economy.

For example, the huge increase in the quantity of money engineered by the Fed over the last year should be cause for inflation in the near future. But if individuals simply choose not to spend, then inflation isn't going to appear. Likewise, the large unfunded government obligations (Medicare, Social Security etc) suggest that either US interest rates should rise or inflation should kick in as government runs the printing presses. But this may not happen if individual investors continue to have faith in the ability of the US government to meet its obligations and continue funding the government's debt. While some would consider this living on borrowed time, the reality is that this "borrowed time" can last for decades and span the bulk of an investor's investing life. In the long run the fundamentals reassert themselves, but the long run could be a meaningless abstraction for an individual's investment lifespan. An investor whose analysis is fundamentally correct could suffer poor returns over his life, while someone riding momentum (or the popular thinking) could ride to riches.

Of course we can't abandon all hope and take a fatalistic view of things. It would be impossible to make any investment decisions if that were to happen. We need to make bets that will play out over the next 5-10 years. Some bets will go wrong and some will work out, and the name of the investing game is simply to have more bets go right than wrong over an investment lifetime. We need to form investment views based on the best data we have, and long term historical averages are one data point in any viewpoint.

The Investing Environment in 2010 and beyond

So what does this mean for us in 2010? It means we must be cognizant that today's investment landscape is marked by 4 key parameters that are likely to define our investing horizon:

(1) The probability that inflation is going to accelerate is high. The key drivers are the large unfunded government liabilities, and the large amount of money injected into the financial system by the Fed. The former will tempt the government to run the printing presses and inflate its way out of its debt hole, while the latter is a huge reservoir of money held back only by people's unwillingness to spend, much like Hoover Dam holds back the Colorado River. When the mood changes, the money will flood out into the economy.

(2) Economic growth is probably going to be low for a few years. The following suggest this:
  • (a) Realignment of economic structure. It is going to take some time to work through the mis-allocation of resources caused by the credit bubble. The structure of economic activity has to be realigned to stop the production of un-needed goods (like excess housing). People need to be re-skilled, and the debts taken on to purchase unproductive assets need to be cleared.

  • (b) Reduction in credit. Banks need to work through their bad assets which will reduce the amount of lending. Credit is the grease that keeps the economic engine running, and its reduction will probably reduce the quantity of economic activity.

  • (c) Demographic changes. Many economically significant countries (the US, China and large parts of Europe) have gone into full scale demographic decline. The aging of baby boomers and China's one child policy mean that going forward, the ratio of retired people to working adults is going to increase. This means both that (1) the structure of economic production will need to change to meet the needs of more older folks, and (2) the amount of production that can take place is going to grow slower or shrink, as there are fewer people of working age to carry out economic activity.

  • (d) Oil and energy. The probability is increasing that real energy costs are going to rise. Fewer easy to extract energy sources means that our EROEI is going to go up. More economic activity has to be generated to produce the same amount of output. The structure of the economy has to change to meet this challenge, either by restructuring our chain of production (which can be analyzed from a biophysical economics / thermoeconomics standpoint) and/or new technologies are going to be invented and the energy architecture of our economy changed.

In short, the probability is that we are headed into a world of low economic growth accompanied by inflation, much like the 1970s. Back then, equities performed terribly, while commodity prices and interest rates rose (i.e. bond prices declined). The question is will history repeat itself in the coming years?

All things considered, increased inflation and slower economic growth is likely to reduce the real earnings of companies and their valuation multiples. Warren Buffett's 1977 article on inflation explains this mechanism very clearly. The gist is that in most cases, companies have not been able to increase their ROEs in times of inflation. This means that they are rarely able to increase earnings beyond their historical average ROE of 12%. This reduces real earnings if inflation increases beyond a dormant 2-4%, and investors penalize company valuations accordingly.

The general remedy for investors is to own companies that have high ROEs. Such companies have room to increase their earnings during inflationary periods by retaining more earnings. However it is important to realize that this ability to increase their earnings in the face of inflation will, all things being equal, not increase their PE valuations. The higher earnings growth rate will likely be countered by the increased discount rate investors require on the future earnings stream.

How investors can profit in this environment

Fundamentally investors profit in three distinct ways:
  1. Capital / Asset preferences. Investors can profit by riding the price rise wave as other investors start converting their capital into a particular asset class. For example, from the early 80s up to 2000, people converted their capital into equities, driving a secular rise in market PE ratios. Investors who caught this wave made a good amount of money. The challenge is to see which assets investors might want to convert their capital into, and then jump in front of that train and ride the asset revaluation uptrend. It is important to distinguish between fundamental price revaluations and asset price bubbles. The difference between the two is the price relative to the underlying economic value generated by the asset. (i.e. the "pe ratio")

  2. Assets that grow economic value add. Investors can also profit by owning assets that continue to increase the amount of real economic value generated over the years. In other words, owning profitable businesses that have a growth path ahead of them.

  3. Betting on events. Another way investors profit is by spotting mis-priced bets. This does require a fair degree of understanding of the environment and parameters underlying the bet, and an appreciation for managing bets. Example of such bets include betting on the weather (which is what P&C insurance underwriters do), and betting on the direction of interest rates.

In the environment that we have for 2010 and beyond, we are likely the face the following parameters for each of these categories of profit-making opportunities:

(A) Capital / Asset preferences
Although there are similarities in the economic backdrop between now and the 1970s, the key difference is that in the 1970s, government was perceived to be functioning better than businesses. Businesses could not keep up with inflation and in some cases were seen as the cause of inflation, whereas the government was seen as an entity that had heft and was attempting to fix problems. It is debatable whether government fixed or created more problems, but the key is that the perception was that government was more a positive force relative to businesses. The backdrop of the cold war and the competing economic philosophies probably had a big influence on this perception. In contrast, the government today is thought of as being in trouble. There is pervasive awareness of the government's debt and under-funded obligations. In contrast, businesses are perceived in a better light, influenced in large part by the positive view of business and capitalism in general from the 1980s onwards, especially after the cold war ended. This makes it probable that investors will not abandon equities en-masse in exchange for government bonds or cash. Their attractiveness is likely to be muted as the people grow more wary of the risk of government default (explicit or implicit via inflation).

Real estate, which would ordinarily be a good inflation hedge, is unlikely to reclaim its role as a store of value because there is a dramatic oversupply of housing stock / commercial space built during the bubble years.

Commodities, another traditional inflation hedge, also face demand softness as the major economies slow down. Unless there is a supply constriction or intensive speculative activity, it is probable that commodity prices will not rise dramatically. (Though it should be noted that prior to 2005, commodities were hitting their lowest prices in decades. So some upwards movement in price, as has happened recently, is to be expected to get back in line with economic fundamentals.)

On the whole, it is probably that no asset class is going to be fundamentally more attractive than the others. Hence it it probable that we will not see a dramatic reallocation of capital between asset classes. (There may be a dramatic reallocation of capital between geographies, but that is a separate discussion.) The soft economy, oversupply of real estate, and "not-cheap" equities also makes it likely that the returns on capital will mediocre for investors in the coming years.

(B) Businesses with growing real economic value add.
One of the perennial investing opportunities is to buy companies whose real economic value add continues to grow over the long term. In other words, companies with sustainable competitive advantages that are taking business away from their competitors and/or riding a mega-trend brought about by changes in fashion, demographics or technology. There are a few key mega-trends that will continue into the next decade or so, which we should pay attention to:

  1. Globalization and Economic Development through the adoption of capitalism:

    (a) Developing countries are improving their incomes and standard of living, potentially benefiting consumer goods companies and infrastructure companies.

    (b) Countries across the world continue to mature their financial systems to allow savings to be channeled into investments in a rule based manner. In most developing countries, large conglomerates thrive at the expense of free competition from smaller/upstart players. In some cases this is due to political connections, but often also because it is difficult for small companies to raise capital to compete. This tends to allow established companies to continue dominating simply because they have access to capital. Maturing financial systems removes the opacity and fund raising obstacles in these countries, and provides growth opportunities for financial services companies.

  2. Electronification of payments; Payments are increasingly becoming electronic, benefiting credit card companies, to the detriment of check and cash handling companies.

  3. The Internet; The information revolution continues unabated, and is continuing to remake the landscape for media companies. It also continues to allow e-commerce companies like Amazon, and information companies like Google to thrive and grow.

  4. Globalization and uniformity of lifestyles. The living experience of people across the globe is becoming increasingly uniform. The information revolution and the way our lives are shaped by universal technologies account for this. A successful concept in one country stands a much better chance of working across the globe today: witness the pervasiveness of Starbucks, mall culture, supermarkets, FMCG products, and so on. Travel to any country in the world today, and you will find a stunning similarity in the consumer experience. Of course local differences have not disappeared completely. Tastes in food and fashion still differ from country to country. For example, Cadbury type chocolate has carried less well in United States, and Hershey type chocolates have found it tough going in many foreign markets. In today's world, a middle class professional in one country is likely to have more in common with a middle class professional in another country, than with his fellow citizens in a different socio-economic strata.

  5. Demographic wave of change - Many countries are aging. This demographic change is made worse in countries like the US by the government's crushing debt and under funded pension and medical benefits plans.
For investors, the key is to invest in companies with sustainable competitive advantages and to find companies with growth possibilities (by riding megatrends or by taking share from competitors).

(C) Betting on Events.
In many areas, the way a large number of events work out is predictable once a sample size is large enough. The insurance industry is founded on this basis. Underwriters make bets on the number of bank robberies in a country, the mortality rate of the population, and so on. P&C insurers even make bets on the weather, for example whether a hurricane is likely to strike an area in a given year.

Sometimes the odds on such bets are good relative to the price of the bet. These mis-priced bets afford an investor the chance to make some money, provided a large enough number of these events can be bet on. The trick is usually finding a large number of mis-priced bets. If you only have one or two instances of the event to bet on, then the law of large numbers that makes the outcome predictable isn't working for you, and you'd be taking a gamble more than an qualified bet.

Another opportunity for betting is when a single event is so extreme that it is an outlier event. In such cases, you only need one event to bet on, because the probability of the bet working out your way is relatively high. Betting on an outlier event is like betting on the movement of a basketball player when he is at the edge of the court. It's a reasonably good bet that he is going to move away from the edge. The number of movement possibilities is reduced, making a bet easier to set up. In contrast, betting on the basketball player's movements when he is in the middle of the court is more like betting on the basis of large numbers. You may know that over a season he is statistically going to move to the right 53% of the time. But it's much less predictable where he is going to go when he is in the middle of the court at a particular time in a particular game.

One key type of outlier event is asset prices, because asset prices tend to revert to a certain mean PE ratio over time. However it is important to be aware that asset price outliers can persist for a very long time. Stocks were at generational lows for more than two decades around the 40s and 50s. Similarly. between 1980 and today, stock prices have generally been raising their average PE value beyond what people in earlier generations would have considered sensible. Asset prices are determined by what other people are willing to pay for it, and people can keep prices up or down for much longer than an individual's investment horizon. So sometimes, it can pay to play outlier event as it continues its way up or down.

The only gradients which as a rule of thumb are better avoided are those that rise incredibly quickly. It is the fact that a collective mania has taken place that drives the speed of the ascent, and it is because the human condition makes collective manias tend to dissipate as quickly as they come, that makes these outliers revert to mean quickly. In other words, they are bubbles waiting to pop. Slowly growing bubbles are more like a cultural conscious that both inflates and deflates slowly, sometimes almost imperceptibly.

Unfortunately there are not many outliers in today's environment. Stock prices are neither cheap nor excessively expensive. The economy's direction is likely to go either way. The huge worldwide government intervention in economies has dampened the natural correction that should have taken place. Instead of a near certain shrinking of economic activity and recessionary consumer psychology, we now have an middle of the road situation where future economic growth or contraction become equally likely possibilities. This makes it difficult to find outlier bets in asset prices.

The only data point that I have seen that is now approaching outlier status is the interest rate. Interest rates are near zero, and they cannot go below that. Though as Japan has shown in practice, they can remain at zero for a very long time.

However, we must beware of "false outliers". A very good example is the government debt, which by all accounts is at a record percentage of the GDP in many developed countries. Government debt is not at an outlier, contrary to common belief. The debt can continue to grow as long as there are people willing to fund it (buy government bonds). New debt can be issued to pay off old debt, and the merry go round goes on as long as people allow it to. As long as people believe the borrower's best days are ahead of it, the circus can continue. The takeaway is that we need to carefully distinguish a true outlier (which has mean reverting tendencies) to record breaking feats, whose records can continue to be broken in successive years.

Investment Themes for 2010

Given this backdrop, what are our investment themes for 2010?
They are:

(1) Look for inflation beating companies. Returns on all asset classes are likely to be muted in the coming years. We will be looking for inflation hedges, with inflation beating companies being prime candidates.

(2) Prepare for asset price declines. The probability is that the equity markets will become cheaper in the near to medium term. So avoid chasing market momentum, and be especially careful of panic buying.

(3) Take outlier bets when the opportunity arises. We can opportunistically bet on outliers when the odds are in our favor. The closest one that is visible on the horizon is interest rates.