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Grahamites
Grahamites
Articles (247) 

What Can We Do Now?

A list of strategies investors can follow in today's environment

The inspiration for this article comes from a combination of Howard Marks (TradesPortfolio)' memo “There They Go Again … Again” and interactions I had with a few friends.

We all know that in the U.S, valuation is elevated, and the risk is high. But the question is what should we do now? This question is as easy as it gets, and it is also as hard as it gets depending on many factors such as whether an investor has figured out the purpose of investing, or whether he or she has well-defined parameters (time horizon, circle of competency, etc.) in which he or she operates. Things become complicated quite easily. Regardless, in general there are few points that are applicable in today’s environment.

1. If you are an individual investor, assuming you know your circle of competency and are investing for the long term, there’s not too much difference in terms of how to invest in today’s market level versus the market level say two years ago, unless some of your holdings are trading at bubblelike valuation levels like Coca-Cola (NYSE:KO) in the late 1990s or the “Nifty Fifties” in the late 1960s and early 1970s, or the tech bubble era. Over a long period of time – at least more than 10 years  valuation changes get smoothed out and business fundamentals dictate investment returns.

2. What you should do now depends on your opportunity cost. Your opportunity cost depends on your investment horizon and required rate of return, both of which need to be well thought out. Let’s say your investment horizon is three to five years and your required rate of return is 15%; you will essentially be comparing what you have now with what the market is offering you that may generate a three- to five-year CAGR of 15%. Because “three to five years” is relatively short, multiple change plays a key role in expected return over this period of time and at today’s valuation levels, there aren’t many companies you can be confident that the valuation levels three to five years from today will be higher than they are now.

3. Whether you should hold cash – again, this topic has been debated many times in the investment world. Holding cash implies that your opportunity set is worse than cash over a defined period of time, which may be true. But to simply hold cash because the market value seems high is almost equivalent to market timing. In a previous article, I’ve argued that the market has appeared to be expensive since probably 2013 using either the Shiller price-earnings (P/E) ratio or the Buffett Indicator (Total market cap/GDP). You have to be almost exactly right on timing; otherwise the opportunity cost is high. There are some “cash substitutes” stocks in the market – it was during last year’s Daily Journal (NASDAQ:DJCO) meeting that Charlie Munger (Trades, Portfolio) said that Warren Buffett (Trades, Portfolio) bought ExxonMobil (NYSE:XOM) as a cash substitute.

4. Amateur investors with a shorter time horizon and professional investors have to struggle with what one should do now – especially professional investors because clients pay money managers to generate returns in all types of market environments. For professional investors, I completely agree with Marks – it’s time to be very cautious and defensive. In the equity market, there are a few ways to be cautious and defensive and not necessarily in a mutually exclusive way.

  • First of all, we can study the past bear markets and see how different stocks behave differently both during the late bull stages leading up to the bear market and during the bear markets. This gives us some sense of what might happen but not what will happen because things are different now. For instance, discounters like Ross Stores (NASDAQ:ROST) and the dollar stores have done relatively well during the past two bear markets. A while ago, when Dollar General (NYSE:DG), Dollar Tree (NASDAQ:DLTR) and Ross were all punished by the market due to the “Amazon (AMZN) effect,” that was a good time to scoop them up.
  • Second, there should be a focus on quality, especially quality companies in defensive sectors such as health care and consumer staples. Of course valuation matters so you have to look for quality companies trading at reasonable multiples. For instance, Allergan (NYSE:AGN) and Kraft Heinz (NASDAQ:KHC) are both high quality companies in defensive sectors (health care and consumer staples) trading at reasonable multiples. But again, you should make sure the companies fall within your circle of competency.
  • Third, one can buy companies that fall under the “work-out” categories that include special situations, international stocks and companies that have low correlation with the U.S. market. For instance, if you can get comfortable with Fairfax, Prem Watsa (Trades, Portfolio) and Africa, Fairfax Africa (FFH.U) might be an interesting option – few people have heard about it; it selectively invests in Africa, about which most U.S. professional investors don’t care; and the capacity to reinvest is high as Africa’s full of opportunities and volatilities.

5. Last but absolutely not least, as I’ve stated many times, what you should do also depends on your personality type (whatever makes you sleep better). Each one of us is different in terms of our comfort level. Before you act on anything, you should remember knowing yourself is still the most important thing.

Some investors asked what I would do in this market environment personally. I manage my own personal portfolio and two other strategies professionally. In my personal portfolio, I concentrate (the five largest positions represent more than 60% of positions) quite a bit on faster compounders such as JD.com (NASDAQ:JD). I also own a few slower compounders like Berkshire Hathaway (NYSE:BRK.B) and Enstar (ESGR). The way I operate in today’s environment is exactly as Point No. 1 above. I always hold some cash because every year there are at least one or two opportunities that only last for a short period of time and I need cash to react.

In the professional strategies I manage, I follow Point No. 4 above. Even at this market level, there’s not much cash in the portfolio although there are a few cash substitute stocks. There’s less concentration (the top 10 positions are roughly 50% only). I own all kinds of companies – high growth, steady compounders, special situation, asset plays and others. Over the past year I’ve cut the proportion of high-growth companies like JD.com and Tencent (TCEHY) and allocated a much higher percentage on high quality defensive names like Allergan, Dollar General, Dollar Tree and Nestle (NSRGY). I’ve also increased the weighting of international stocks that have low correlations with the U.S. market like Fairfax Africa mentioned above.

Disclosure: Long Allergan, Berkshire Hathaway, Dollar General, Dollar Tree, Fairfax Africa, JD.com, Nestle, Tencent and ExxonMobil.


Rating: 4.7/5 (7 votes)

Voters:

Comments

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Great stuff Grahamites. In my client accounts I'm sitting on 15-25% cash. The sole decision to hold cash is if a.) the price of an existing holding far exceeds estimated intrinsic value and I cash out and b.) no company in my investment universe (around 140 - 160 companies) meets my investment criteria prohibiting allocation of capital. I am completely market agnostic. Thanks again for a great article. Best. - Tom

jtdaniel
Jtdaniel premium member - 2 months ago

Hi Grahamites,

Great and timely article. I was pleasantly surprised to learn that you are long Exxon-Mobil, my go-to dividend stock. With each passing year, I gain a deeper appreciation for the value of a rising dividend that could be reinvested. Of course Exxon will outperform cash over a reasonable time period. I was wondering if you are still in DaVita. It looks like the right kind of stock for this investing environment and I recently began buying in the $57's. Best, dj

Grahamites
Grahamites premium member - 2 months ago

Tom - Very intelligent portfolio decisions. I can't agree more:) Thanks for commenting.

Grahamites
Grahamites premium member - 2 months ago

Dj - I can't take any credits for XOM. I took it from Munger and it was mainly a cash substitute for a non-profit account I manage, not in my personal account. With DaVita, I was wrong in not recognizing the tectonic shift in the reimbursement environment and in being way too early on the healthcare partners business. I've cut my holdings of DVA significantly a while ago. Low single digit owners earnings growth does not strike me as very attractive, even at today's price. But I could be wrong on DVA. It's a complicated business, especially the capitation business (HCP part). I've come to the conclusion that I have to acknowledge there's too much I don't know about it.

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

Hi Grahamites, interesting article and topic,

i ve no general fit all answer (as you say it depends on personal finance situation, family needed and time orizon, personal investment ability , type of temperament ecc)

I would only add at the discussions what I m actually doing with my money :

I ve Made my last buy (ynap.mi) in July 2016

second last buy (TIP.mi) in January 2016

I patiently sit on my assets, studing few companies , reading , keep my eyes open but enjoying my time with family and friend.

If I will I find a really big opportunity tomorrow I would act (no matter where the general markets is) if not I will simply continue to wait... no problem for me.

i don't reinvest any dividend, I simply let my holding compounds and the side cash build up.

I ve no cash target/ limits , no idea on where the market will be next month or next year .... and I actually don't even care much.

I ve just 6 holdings... one from 2009 , one from 2010...

I ve take seriously the munger/fisher ways of being really patient and really selective

Thanks for sharing and good day to you , JT , Tom and Everyone

Snow

raj123456789
Raj123456789 - 2 months ago    Report SPAM

Hi Snowball, if you dont mind, may I ask what you bought in 2009 and 2010. I bought brk and wfc in 2008 to 2012(70% of portfolio then).

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