The more you read, the more you learn. A pretty obvious concept really. I promised myself after the stock market collapse of 2008 that I would pay more attention to well researched opinions of successful investors. I had followed Fairfax Financial and Prem Watsa for the years leading up to the housing collapse so based on their warnings I knew that the various financial institutions were going to be in trouble. What I didn’t really appreciate or believe was how far outside of the companies holding the toxic securities the problems would spread.
For example I had no thoughts of plummeting oil prices, or the fact that resource companies would be completely cut off from capital as all capital markets froze. Fairfax however was positioned for complete chaos in the market, and in addition to their big bet on CDS positions also had virtually entirely hedged their equity portfolio heading into the crisis. I should have listened more carefully and prepared myself to be a beneficiary of the situation.
So in an effort to keep forcing myself to think and learn here are some thoughts from East Coast Asset Management that appear in their latest quarterly letter which is posted on the internet:
“The concluding agenda item of our weekly investment meetings is to re-visit a list we maintain called “where is the crowd - where is the edge?” This is where we elevate our thought process to the 30,000 foot level and take view of where we believe the greatest amount of consensus thought (think concentric circle) is taking place and conversely identify what resides on the edge of that consensus thinking. Over time an investor following the crowd will be at best destined to mediocre returns and at the worst of times will, in lemming-like fashion, take the leap off the cliff and register a permanent loss of capital. The path toward generating truly exceptional long-term compounded returns is to have a differentiated view built on business sense and harnessed through a repeatable process. The table below highlights our most recent list.
1. Everyone is a macro-economist: The current focus on the macro view is unprecedented –
at no time during our respective careers have we ever seen this view so skewed. We have
incorporated a global macro overlay to our bottom up approach of looking at the expected
return of each investment; however, we believe future returns will be less directional on
macro stimuli and more influenced by the merit of the investment. We find it more
constructive to look at micro themes that create sector tailwinds supporting certain
industries and company fundamentals. Each week we rank the expected return and the
quality attributes of our universe of businesses and maintain a list of our top five micro
themes, where each is stewarded by an analyst for data point updates. Compelling
opportunities continue to percolate from both areas while the world wrestles with the
noise of the macro. We expect to be rewarded handsomely from these areas of focus
over the cycle.
2. Binary extreme conclusions of inflation/deflation: In the same vein as an overly macro
consensus, we also observe that investors are paralyzed by the belief they need to
correctly assess whether we are in a period of prolonged inflation or deflation. The
arguments towards deflation are ones that have merit over the short-term based on excess
capacity; however, they have zero weight over the mid-long term. With Ben Bernanke
leading the charge to fight deflationary forces we conclude the mantra at the Fed is
“Never again.” Never again will this Fed prematurely remove stimulus given the lessons
learned in the Great Depression and more recently in Japan. A very instructive summary
of Bernanke’s thoughts in this regard can be found in a March 2003 speech he made to
the Japan Society of Monetary Economics in Tokyo, Japan4. We quote directly from the
conclusion of the speech “With protracted deflation, however, excessive money creation
is unlikely to be the problem.” We were also very interested in reviewing the transcripts
of the European Union’s response the Greece bailout. The net effect was a decision to use
quantitative easing to deal with the bailout needs of the less fiscally sound members of
the union. Milton Friedman’s words echo in infinity-“inflation is always and everywhere
a monetary phenomenon.”
Buffett’s recent New York Times Op-Ed5 comments are timeless, “Legislators will
correctly perceive that either raising taxes or cutting expenditures will threaten their reelection.
To avoid this fate, they can opt for high rates of inflation, which never require a
recorded vote and cannot be attributed to a specific action that any elected official takes.”
We believe we know the end game without joining in the consensus guessing short-term
moves, and are positioned to protect not only principal but purchasing power. The
short-term money supply moves could offset deflation but at some point stimulus will not
be able to be pulled back quick enough and inflation will leak out – to what degree
remains unknown - thus we seek to protect against this mid-long term inflation risk to the
best degree possible.
3. Flood to fixed-income: We have seen an unprecedented flood of new money into fixed income investments as investors are forced out of what they perceive to be a foolish
decision to earn Bernanke’s zero percent interest rates. Investors have inadvertently put
themselves into a position of significant risk. We foresee the cost of money rising to
reflect the true effects of what quantitative easing does to the value of money. It strikes
us as absurd to agree to receive 3% plus a record low corporate spread (145bps) to loan
money only to receive your depreciated fixed principal back in the future. Yet, investors
have moved over $450Bl of net new funds to this asset class over the last 16 months. If
yields move from 3% to 7% which we believe they will (at the very least) and corporate
spreads widen to 350bps from 145 bps, we expect the Barclays Aggregate Index with an
average maturity of 7 years to correct between 25 – 40%. This will be a catastrophic
shock to the unknowing individual investor who has allocated out of “risky” equities and
into “safe” bonds.
4. Inflation protection through TIPS and floating rate bonds: An underlying TIP is
equivalent to owning a ten year treasury with an adjustment for CPI. The government
keeps the scorecard on CPI and has changed its definition for calculating this metric for
its own benefit countless times. We expect the ten year to rise dramatically and believe
that CPI will be a lagging and manipulated indicator of real inflation. To that point we
gain no real satisfaction in owning this protection. The shorter duration TIPS (which are
now 5 years) have some merit but they are by no means an ideal hedge. We continue to
monitor floating rate bonds as the most interesting investment du jour. The investor
believes as interest rates climb they in turn will be protected as their income will climb
with Libor rates which currently hover around 0.30%. As we looked at the underlying
issuers we found areas for concern. Investors do not realize the risky credit profiles of
these businesses that have no fixed-rate refinance options, even in an environment where
liquidity is being provided hand over fist. We wrote about this in our last letter and
during this period of dislocation some of these floating rate bond funds dropped nearly
20% during a phase when Libor was climbing. Caveat Emptor!
5. Gold – weak holders: Gold is reaching new highs and thus there is speculative fervor to
increase gold allocations. However, speculators appear skittish with one foot through the
door and their hand on the exit. We increased our allocation to gold early in the second
quarter and have recently been building a position in silver. Our views differ from the
consensus; we believe gold and silver are only an effective store of value when the
world’s reserve currencies are being debased. Gold will do materially better relative to
developed world currencies. We have seen this occur in 2010 with gold +13% year-todate.
We also have this view in light of a very small opportunity cost of owning gold as
we are using cash that we have tactically allocated away from credit investments. We
make investments with a mid-long term horizon and expect to own gold through periods
of volatility as long as the underlying thesis remains in-tact.
Recently we met with Greenlight Capital in New York, where we gained additional
insight on the reasoning behind David Einhorn’s decision to create a fund that is
completely backed by gold. We were interested to hear that their conviction in currency
debasement and hence a large gold position was so strong they wanted to express this
view in a degree greater than their existing funds mandate. Intelligent capital and
sovereigns are materially changing their views on the efficacy of precious metals for
positive absolute returns versus fiat currency depreciation. Even modest supply-demand
shifts would move prices materially higher. We will continue to assess the proper weight
of this investment in light of central bank money supply activity.
6. Overly bearish and emotional conclusions – extreme volatility: We have and will
continue to see extreme volatility as the world draws macro conclusions. These periods of
volatility have historically generated unprecedented buying opportunities. Below we
have highlighted the VIX index which is a good representation of the emotion of the
markets. Periods of heightened volatility, as we have today with a reading near 40, have
been inflection points where we have seen the beginning of major bull moves in
compounded rates of return in equities. While we do not put too much weight on these
technical indicators, it is hard to ignore these readings and how they correlate with the
current overly bearish sentiment. We feel this is a very bullish sign for things to come.
7. Short time horizons: Time horizons have shortened dramatically as seen during the
depths of the credit bubble where an economic Pearl Harbor was taking place. Investors
are putting very little value on the long-term implications of a business’s competitive
advantage, absolute valuation attractiveness, and bond yields versus long-term inflation
rates. The focus is on the here and now. Investors with a differentiated view on time
horizon (mid-long) will be rewarded extensively; this is one of the great free lunches
available today.
8. Leverage is no longer a corporate noose: Interest rates will climb dramatically, credit
spreads will normalize to the true risk of these indebted companies. We are avoiding
equity with large debt loads and have unwound much of our corporate bonds as credit
spreads have come in to pre-crisis levels.
9. Inferior companies can thrive in this new world of bailouts: Markets have rewarded
inferior businesses with full valuations while their indebtedness remains since the Fed
stepped in to support financial and corporate balance sheets. The true funding costs of
these liabilities will expose themselves through the cycle and many of these businesses
will be significantly constrained. This is when the strong, competitively advantaged
businesses will have an opportunity to gain share. The true merit of quality versus lower
quality will be clear. Investors will look back at this moment in time and see this period
as one of the best opportunities to own great businesses at reasonable prices. Pricing
power opportunities will serve as a tailwind as inflation exposes itself to the light of day.
10. Complexity: Yield chasers learned the hard lessons of the dangers of a prolonged period
of low interest rates. Investors seeking greater returns than cash will seek out alternatives
and will look to more complex securities to arrive at moderate yield advantages. This
equates to taking on unforeseen risks as we saw in the mortgage backed security market.
Today it might be showing up in owning floating rate bonds, guaranteed investment
contracts, and fixed-income mutual funds that have lengthened durations in front of a
bond bubble to site a few examples. We believe the variant perception and the edge of
this thinking is simplicity. Owning a fractional interest in a business that commands
global advantages and has pricing power is a reasonable idea. Owning these businesses
at valuation troughs in PE Multiples, attractive free cash flow yields, robust dividend
yields, with no debt constraints, and with market share growth opportunities is a
spectacularly simple and prudent decision.
Portfolio Positioning – Then and Now – Our Broad Views:
We have been implementing a decisive, prudent, and disciplined strategy to protect against the
heightened risk of purchasing power erosion. As many of our portfolio construction decisions
and broad views remain intact from the last quarter’s letter, we felt it was important to restate
those views and include additional information where appropriate.
ô€¸ Then and Now: The first quarter of 2009 marked an inflection point where we moved from
the low-end of our asset allocation ranges in equities and gravitated toward the higher-end of
our clients’ customized ranges. We will always allocate capital based on valuation. As
value investors, our view of the quality of the investment drills down to what we expect to
extract from that opportunity in cash – all income plus return of our principal. We compare
this expectation of return (IRR) to all investment alternatives across all asset classes. This
said, high quality global equities have represented the best expected total return from a
valuation perspective. They also share the important attribute of being an effective inflation
hedge for those companies that have the ability to raise prices with inflation or have tangible
assets that are being reflated. We made investments during the periods of dislocation in the
4th quarter of 2008 and 1st quarter of 2009 that have paid off handsomely to date. These
views continue to shape the composition of our portfolio.
ô€¸ Broad Views:
o The “Q” Component - Quality: Just as we saw a low quality rally after the lows in
2003, we have seen a rally in lower quality companies versus higher quality since the
lows in March of 2009. Higher quality businesses are poised for deferred
outperformance. Examples of high quality names are: Nestle, Waste Management,
Colgate, Coca Cola, Novartis, and Express Scripts. These companies trade near the
low-end of their 20 year range of valuation multiples. Businesses that have scale
advantages, and who are industry price-setters, have the very important characteristic
of being an inflation hedge.
Jeremy Grantham echoed our views on this anomaly in his April 2010 quarterly
newsletter. Take our word for it - this is as glowing a recommendation as you will
get from Jeremy.
“Surprisingly, within the U.S. the large high quality companies are still a little
cheap, having been left behind in the rally. They are unlikely to do very well in a
bubbly environment, however long it lasts, but should be great in declines and in
the end should win. A potential plus for quality franchise stocks in the next few
years is that they are far more exposed to emerging countries and , as investors
fall in love with all things emerging, this should be seen as an increasing
advantage. A mix of global stocks, titled to U.S. high quality, has a 7-year asset
class forecast of about 5% excluding inflation compared with a long-term normal
of about 6%. Not so bad.”
o Tangible Assets and Natural Resources: We have a global reflationary environment
where central banks are increasing the money supply to levels not previously seen.
At the same time, we are in a period of contracted global growth as the world
deleverages from the credit bubble. Therefore, we have a lot of capacity that will
remain underutilized. Where will all the excess money flow? It will flow into assets
and more specifically into real assets. While we do not view real-estate as an
attractive asset class as it works off its own excesses, we are favoring resource rich
countries and companies that have tangible assets.
o Gold: With cash and near-cash investments earning very low interest rates, our
opportunity cost is low to shield some of our fixed-income allocation from inflation.
We have and will continue to look at gold in this way. We do not like many of its
characteristics as it pays nothing in income, it incurs indirect storage costs, and very
little gold has been used up. John Paulson summed up two reasons an investor would
want to own gold when he spoke at the Grant’s conference in New York in the Fall of
2009. One was the “fear factor” which is a hedge against Armageddon; the second
factor, and principal source of gold demand, is that of a protection against currency
debasement. Paulson explains: “Demand for gold as an inflation hedge is, for me,
100 – 1000 times more than the demand for the ‘fear factor.’” There are many
people, institutions, and countries that are holding major reserves in “fiat” paper
currencies that are being debased. We expect a sustained rally in the price of gold
and we find it an effective parking spot for money that is not earning an adequate
interest rate and that is not shielded from inflation risk. We look forward to the day
that we will remove the gold allocation from our portfolio.
o Emerging Market Consumer: the countries of Brazil, China and India represent a
vast opportunity for investment over the coming decades. While these countries face
serious headwinds given their weak export markets, there exists an emerging
consumer economy which will reward investments that may be domiciled in these
countries or that are global franchises that sell their goods and services into these
countries. We will not overpay for growth, but will challenge ourselves to devote
resources to uncover great opportunities in these markets based upon sound
investment principles.
o Fixed-Income: Interest rates are poised for significant and prolonged upward move.
We have been telling you that interest rates will rise to reflect the risk to a bond
holder of getting dollars back that are worth less. An interest rate of 3.66% for a 10
year Treasury bond and 4.53% for a 30 year Treasury bond is not a sufficient return
for a bond holder. Rates are being kept artificially low as the Fed has been buying
Treasuries. They have, in fact, made up 100%+ of the demand for the net-new
issuance of Treasuries. This is not sustainable. Spreads have narrowed over the last
several months and interest rates on quality corporate bonds are not interesting
enough for us to allocate capital to that space.
For example I had no thoughts of plummeting oil prices, or the fact that resource companies would be completely cut off from capital as all capital markets froze. Fairfax however was positioned for complete chaos in the market, and in addition to their big bet on CDS positions also had virtually entirely hedged their equity portfolio heading into the crisis. I should have listened more carefully and prepared myself to be a beneficiary of the situation.
So in an effort to keep forcing myself to think and learn here are some thoughts from East Coast Asset Management that appear in their latest quarterly letter which is posted on the internet:
“The concluding agenda item of our weekly investment meetings is to re-visit a list we maintain called “where is the crowd - where is the edge?” This is where we elevate our thought process to the 30,000 foot level and take view of where we believe the greatest amount of consensus thought (think concentric circle) is taking place and conversely identify what resides on the edge of that consensus thinking. Over time an investor following the crowd will be at best destined to mediocre returns and at the worst of times will, in lemming-like fashion, take the leap off the cliff and register a permanent loss of capital. The path toward generating truly exceptional long-term compounded returns is to have a differentiated view built on business sense and harnessed through a repeatable process. The table below highlights our most recent list.
1. Everyone is a macro-economist: The current focus on the macro view is unprecedented –
at no time during our respective careers have we ever seen this view so skewed. We have
incorporated a global macro overlay to our bottom up approach of looking at the expected
return of each investment; however, we believe future returns will be less directional on
macro stimuli and more influenced by the merit of the investment. We find it more
constructive to look at micro themes that create sector tailwinds supporting certain
industries and company fundamentals. Each week we rank the expected return and the
quality attributes of our universe of businesses and maintain a list of our top five micro
themes, where each is stewarded by an analyst for data point updates. Compelling
opportunities continue to percolate from both areas while the world wrestles with the
noise of the macro. We expect to be rewarded handsomely from these areas of focus
over the cycle.
2. Binary extreme conclusions of inflation/deflation: In the same vein as an overly macro
consensus, we also observe that investors are paralyzed by the belief they need to
correctly assess whether we are in a period of prolonged inflation or deflation. The
arguments towards deflation are ones that have merit over the short-term based on excess
capacity; however, they have zero weight over the mid-long term. With Ben Bernanke
leading the charge to fight deflationary forces we conclude the mantra at the Fed is
“Never again.” Never again will this Fed prematurely remove stimulus given the lessons
learned in the Great Depression and more recently in Japan. A very instructive summary
of Bernanke’s thoughts in this regard can be found in a March 2003 speech he made to
the Japan Society of Monetary Economics in Tokyo, Japan4. We quote directly from the
conclusion of the speech “With protracted deflation, however, excessive money creation
is unlikely to be the problem.” We were also very interested in reviewing the transcripts
of the European Union’s response the Greece bailout. The net effect was a decision to use
quantitative easing to deal with the bailout needs of the less fiscally sound members of
the union. Milton Friedman’s words echo in infinity-“inflation is always and everywhere
a monetary phenomenon.”
Buffett’s recent New York Times Op-Ed5 comments are timeless, “Legislators will
correctly perceive that either raising taxes or cutting expenditures will threaten their reelection.
To avoid this fate, they can opt for high rates of inflation, which never require a
recorded vote and cannot be attributed to a specific action that any elected official takes.”
We believe we know the end game without joining in the consensus guessing short-term
moves, and are positioned to protect not only principal but purchasing power. The
short-term money supply moves could offset deflation but at some point stimulus will not
be able to be pulled back quick enough and inflation will leak out – to what degree
remains unknown - thus we seek to protect against this mid-long term inflation risk to the
best degree possible.
3. Flood to fixed-income: We have seen an unprecedented flood of new money into fixed income investments as investors are forced out of what they perceive to be a foolish
decision to earn Bernanke’s zero percent interest rates. Investors have inadvertently put
themselves into a position of significant risk. We foresee the cost of money rising to
reflect the true effects of what quantitative easing does to the value of money. It strikes
us as absurd to agree to receive 3% plus a record low corporate spread (145bps) to loan
money only to receive your depreciated fixed principal back in the future. Yet, investors
have moved over $450Bl of net new funds to this asset class over the last 16 months. If
yields move from 3% to 7% which we believe they will (at the very least) and corporate
spreads widen to 350bps from 145 bps, we expect the Barclays Aggregate Index with an
average maturity of 7 years to correct between 25 – 40%. This will be a catastrophic
shock to the unknowing individual investor who has allocated out of “risky” equities and
into “safe” bonds.
4. Inflation protection through TIPS and floating rate bonds: An underlying TIP is
equivalent to owning a ten year treasury with an adjustment for CPI. The government
keeps the scorecard on CPI and has changed its definition for calculating this metric for
its own benefit countless times. We expect the ten year to rise dramatically and believe
that CPI will be a lagging and manipulated indicator of real inflation. To that point we
gain no real satisfaction in owning this protection. The shorter duration TIPS (which are
now 5 years) have some merit but they are by no means an ideal hedge. We continue to
monitor floating rate bonds as the most interesting investment du jour. The investor
believes as interest rates climb they in turn will be protected as their income will climb
with Libor rates which currently hover around 0.30%. As we looked at the underlying
issuers we found areas for concern. Investors do not realize the risky credit profiles of
these businesses that have no fixed-rate refinance options, even in an environment where
liquidity is being provided hand over fist. We wrote about this in our last letter and
during this period of dislocation some of these floating rate bond funds dropped nearly
20% during a phase when Libor was climbing. Caveat Emptor!
5. Gold – weak holders: Gold is reaching new highs and thus there is speculative fervor to
increase gold allocations. However, speculators appear skittish with one foot through the
door and their hand on the exit. We increased our allocation to gold early in the second
quarter and have recently been building a position in silver. Our views differ from the
consensus; we believe gold and silver are only an effective store of value when the
world’s reserve currencies are being debased. Gold will do materially better relative to
developed world currencies. We have seen this occur in 2010 with gold +13% year-todate.
We also have this view in light of a very small opportunity cost of owning gold as
we are using cash that we have tactically allocated away from credit investments. We
make investments with a mid-long term horizon and expect to own gold through periods
of volatility as long as the underlying thesis remains in-tact.
Recently we met with Greenlight Capital in New York, where we gained additional
insight on the reasoning behind David Einhorn’s decision to create a fund that is
completely backed by gold. We were interested to hear that their conviction in currency
debasement and hence a large gold position was so strong they wanted to express this
view in a degree greater than their existing funds mandate. Intelligent capital and
sovereigns are materially changing their views on the efficacy of precious metals for
positive absolute returns versus fiat currency depreciation. Even modest supply-demand
shifts would move prices materially higher. We will continue to assess the proper weight
of this investment in light of central bank money supply activity.
6. Overly bearish and emotional conclusions – extreme volatility: We have and will
continue to see extreme volatility as the world draws macro conclusions. These periods of
volatility have historically generated unprecedented buying opportunities. Below we
have highlighted the VIX index which is a good representation of the emotion of the
markets. Periods of heightened volatility, as we have today with a reading near 40, have
been inflection points where we have seen the beginning of major bull moves in
compounded rates of return in equities. While we do not put too much weight on these
technical indicators, it is hard to ignore these readings and how they correlate with the
current overly bearish sentiment. We feel this is a very bullish sign for things to come.
7. Short time horizons: Time horizons have shortened dramatically as seen during the
depths of the credit bubble where an economic Pearl Harbor was taking place. Investors
are putting very little value on the long-term implications of a business’s competitive
advantage, absolute valuation attractiveness, and bond yields versus long-term inflation
rates. The focus is on the here and now. Investors with a differentiated view on time
horizon (mid-long) will be rewarded extensively; this is one of the great free lunches
available today.
8. Leverage is no longer a corporate noose: Interest rates will climb dramatically, credit
spreads will normalize to the true risk of these indebted companies. We are avoiding
equity with large debt loads and have unwound much of our corporate bonds as credit
spreads have come in to pre-crisis levels.
9. Inferior companies can thrive in this new world of bailouts: Markets have rewarded
inferior businesses with full valuations while their indebtedness remains since the Fed
stepped in to support financial and corporate balance sheets. The true funding costs of
these liabilities will expose themselves through the cycle and many of these businesses
will be significantly constrained. This is when the strong, competitively advantaged
businesses will have an opportunity to gain share. The true merit of quality versus lower
quality will be clear. Investors will look back at this moment in time and see this period
as one of the best opportunities to own great businesses at reasonable prices. Pricing
power opportunities will serve as a tailwind as inflation exposes itself to the light of day.
10. Complexity: Yield chasers learned the hard lessons of the dangers of a prolonged period
of low interest rates. Investors seeking greater returns than cash will seek out alternatives
and will look to more complex securities to arrive at moderate yield advantages. This
equates to taking on unforeseen risks as we saw in the mortgage backed security market.
Today it might be showing up in owning floating rate bonds, guaranteed investment
contracts, and fixed-income mutual funds that have lengthened durations in front of a
bond bubble to site a few examples. We believe the variant perception and the edge of
this thinking is simplicity. Owning a fractional interest in a business that commands
global advantages and has pricing power is a reasonable idea. Owning these businesses
at valuation troughs in PE Multiples, attractive free cash flow yields, robust dividend
yields, with no debt constraints, and with market share growth opportunities is a
spectacularly simple and prudent decision.
Portfolio Positioning – Then and Now – Our Broad Views:
We have been implementing a decisive, prudent, and disciplined strategy to protect against the
heightened risk of purchasing power erosion. As many of our portfolio construction decisions
and broad views remain intact from the last quarter’s letter, we felt it was important to restate
those views and include additional information where appropriate.
ô€¸ Then and Now: The first quarter of 2009 marked an inflection point where we moved from
the low-end of our asset allocation ranges in equities and gravitated toward the higher-end of
our clients’ customized ranges. We will always allocate capital based on valuation. As
value investors, our view of the quality of the investment drills down to what we expect to
extract from that opportunity in cash – all income plus return of our principal. We compare
this expectation of return (IRR) to all investment alternatives across all asset classes. This
said, high quality global equities have represented the best expected total return from a
valuation perspective. They also share the important attribute of being an effective inflation
hedge for those companies that have the ability to raise prices with inflation or have tangible
assets that are being reflated. We made investments during the periods of dislocation in the
4th quarter of 2008 and 1st quarter of 2009 that have paid off handsomely to date. These
views continue to shape the composition of our portfolio.
ô€¸ Broad Views:
o The “Q” Component - Quality: Just as we saw a low quality rally after the lows in
2003, we have seen a rally in lower quality companies versus higher quality since the
lows in March of 2009. Higher quality businesses are poised for deferred
outperformance. Examples of high quality names are: Nestle, Waste Management,
Colgate, Coca Cola, Novartis, and Express Scripts. These companies trade near the
low-end of their 20 year range of valuation multiples. Businesses that have scale
advantages, and who are industry price-setters, have the very important characteristic
of being an inflation hedge.
Jeremy Grantham echoed our views on this anomaly in his April 2010 quarterly
newsletter. Take our word for it - this is as glowing a recommendation as you will
get from Jeremy.
“Surprisingly, within the U.S. the large high quality companies are still a little
cheap, having been left behind in the rally. They are unlikely to do very well in a
bubbly environment, however long it lasts, but should be great in declines and in
the end should win. A potential plus for quality franchise stocks in the next few
years is that they are far more exposed to emerging countries and , as investors
fall in love with all things emerging, this should be seen as an increasing
advantage. A mix of global stocks, titled to U.S. high quality, has a 7-year asset
class forecast of about 5% excluding inflation compared with a long-term normal
of about 6%. Not so bad.”
o Tangible Assets and Natural Resources: We have a global reflationary environment
where central banks are increasing the money supply to levels not previously seen.
At the same time, we are in a period of contracted global growth as the world
deleverages from the credit bubble. Therefore, we have a lot of capacity that will
remain underutilized. Where will all the excess money flow? It will flow into assets
and more specifically into real assets. While we do not view real-estate as an
attractive asset class as it works off its own excesses, we are favoring resource rich
countries and companies that have tangible assets.
o Gold: With cash and near-cash investments earning very low interest rates, our
opportunity cost is low to shield some of our fixed-income allocation from inflation.
We have and will continue to look at gold in this way. We do not like many of its
characteristics as it pays nothing in income, it incurs indirect storage costs, and very
little gold has been used up. John Paulson summed up two reasons an investor would
want to own gold when he spoke at the Grant’s conference in New York in the Fall of
2009. One was the “fear factor” which is a hedge against Armageddon; the second
factor, and principal source of gold demand, is that of a protection against currency
debasement. Paulson explains: “Demand for gold as an inflation hedge is, for me,
100 – 1000 times more than the demand for the ‘fear factor.’” There are many
people, institutions, and countries that are holding major reserves in “fiat” paper
currencies that are being debased. We expect a sustained rally in the price of gold
and we find it an effective parking spot for money that is not earning an adequate
interest rate and that is not shielded from inflation risk. We look forward to the day
that we will remove the gold allocation from our portfolio.
o Emerging Market Consumer: the countries of Brazil, China and India represent a
vast opportunity for investment over the coming decades. While these countries face
serious headwinds given their weak export markets, there exists an emerging
consumer economy which will reward investments that may be domiciled in these
countries or that are global franchises that sell their goods and services into these
countries. We will not overpay for growth, but will challenge ourselves to devote
resources to uncover great opportunities in these markets based upon sound
investment principles.
o Fixed-Income: Interest rates are poised for significant and prolonged upward move.
We have been telling you that interest rates will rise to reflect the risk to a bond
holder of getting dollars back that are worth less. An interest rate of 3.66% for a 10
year Treasury bond and 4.53% for a 30 year Treasury bond is not a sufficient return
for a bond holder. Rates are being kept artificially low as the Fed has been buying
Treasuries. They have, in fact, made up 100%+ of the demand for the net-new
issuance of Treasuries. This is not sustainable. Spreads have narrowed over the last
several months and interest rates on quality corporate bonds are not interesting
enough for us to allocate capital to that space.
