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Playing a Game of Economic Survivor

April 01, 2014
I don’t do writing assignments. I don’t like deadlines. I am not a writer; I am an investor who thinks through writing. So when Institutional Investor asked me to write on the future of investing, my instinct was to politely decline. But the topic did seem intriguing. So I decided to give it a try.

At first, I felt like I needed a healthy dose of Prozac to tackle the article — it is easy to get depressed about the global economy. Europe is on the verge of disintegration; China risks a hard crash landing; Japan is a prick away from its debt bubble bursting; and emerging economies are too linked to China. The U.S., whose GDP grew at a less than inspiring annual rate of 1.5 percent in the second quarter, is the least-spoiled banana in the whole rotten fruit basket, the valedictorian of summer school. As I put down these words, the thought that came to mind was, Do I really want to be responsible for other people’s life savings in this tumultuous environment? Maybe I should learn to love deadlines and take up writing as a career.

But when I step back and look at the past 100 years, I’m reassured by all the things that the U.S. and global economies survived: pandemics that wiped out a percentage of the global population, two “hot” world wars and a cold war, the disintegration of a superpower, plenty of other wars, a few nuclear plant meltdowns, economic collapses, terrorist attacks on U.S. soil, stock market crashes, and I’m sure I’m forgetting a slew of other bad things. Somehow our economy (and economies that were affected a lot more than ours) got through those things. Our will to survive is so much stronger than any adversity.

Pause for a second. Put yourself in any moment in the past century. There was always something terrible happening that seemed like it was going to tip us over the edge of the cliff. And every bad time seemed uniquely bad. But I suspect that, outside of a giant meteor hitting the earth, the global economy will survive whatever adversity is thrown at it.

An economy doesn’t need a fertile ground of calmness and abundance to thrive. Just think of Japan, a nation living on a few big rocks, with no natural resources, in the middle of the Pacific, surviving and prospering after two nuclear bombs obliterated two of its largest cities — a country constantly abused by earthquakes and tsunamis (“tsunami” is a Japanese word). Despite all that, Japan developed into one of the most prosperous nations in the world, with one of the highest life expectancies. Or think of Israel, a thriving democracy of fewer than 8 million people, surrounded by half a billion “friends.”

There are a lot of bad things brewing on the horizon, and I’d be the last person to tell you to bury your head in the sand, pray to the gods of blissful ignorance, and just hope for the best. Bad things will happen, but we’ll survive, and if history is prologue, we’ll come out stronger. In the meantime, I’ll take the advice of Oaktree Capital Management co-founder Howard Marks (Trades, Portfolio), who likes to say, “You cannot predict, but you can prepare.”

It is still not too late to structure your portfolio to weather the global storm. The key is to own quality. For me, quality companies are the ones that need to exist, that you can imagine being around five or even 50 years from now. They also usually come with wide moats that protect them from competition trying to take a bite out of their cash flows.

Companies with pricing power will protect you both in an inflationary environment, by passing price increases on to their customers, and during deflationary times, by maintaining their prices. Strong balance sheets are not really appreciated in an environment where everyone is drowning in liquidity, but they will be appreciated by scared creditors when things go bad. There is a tremendous value in the recurrence of revenue; companies with plenty of it have to do less heavy lifting to grow.

Don’t pay high multiples for growth; you are setting yourself up for disappointment. Returns for stocks are driven by two factors: earnings growth and price-to-earnings expansion or contraction. The external environment may not be kind to earnings growth (the aforementioned recurring revenue will fight for this on your behalf), but a stock bought at a significant discount to fair value puts you on the right side of the P/E trend and can handle a lot of bad news thrown at it. In the longer run it will see P/E expansion.

Dividends are also important. They force management to focus on cash flow — dividends are paid out with cash, not with earnings — and serve as a deterrent to dumb empire-building, value-destroying acquisitions.

If you cannot find enough companies that fit the above criteria, default to cash. Even if we experience inflation, cash is better than a bad stock.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).


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