converging viewpoints

4 Oct

Over the past month I’ve been mostly out of the portfolio management game, and it has been titillating (to make use of an oft-unused word) from a personal standpoint to watch the capital markets from the sidelines.  There is a constant need for client management, nearly as much as actually managing money, when managing portfolios.  And when markets are volatile and the world seems more uncertain, client management can be nearly, or more, time consuming than actually trying to add value to managed assets.  I have been able to view it through another lens and it has been fascinating.

The above is not the main subject of this post.

Though I am not actively managing client assets, I am still deeply involved in thinking about the economy, capital markets, and specific investments.  In that vein, I’ve been corresponding with a friend about the situation in the world today.  Europe finds itself in crisis.  The U.S. may be in another recession and is growing anemically at the very least.  Or that’s the way the world – viewed through the media – now seems to portray it.

My friend has always been at odds with the prevailing view of the world.  He’s been a heavy investor in foreign currencies and gold, and short the market from time to time.  Not really the buy and hold type.  Today he was lamenting that he seems to have lost his footing.  That is, the investment world seems to be saying the things he’s been saying for years.  “Wait, you agree with me?  I’m not used to that!”  When a contrarian opinion becomes consensus, it often leads to these awkward feelings.  I’ve been there myself several times.

While I’m not a ‘buy gold, the world will eventually collapse’ investor, I do think we are in what would technically be a depression.  But it’s ongoing deleveraging that leads me to that conclusion, not a hatred of Western society or the President.  (Not that my friend is motivated by these, either.)  Robust economic growth the past couple decades was borrowed from the future in the form of private and public sector debt used for consumption more than long-term asset building.  This must be now paid down.  Put matter-of-fact-ly, aggregate growth will be lower no matter what fiscal and/or monetary efforts are wielded against it. I came to this conclusion around the same time others did, albeit independently, during late 2008.  History foretells what is bound to happen out of similar conditions and this is an experiment we’ve seen run before.

Back to the main point.  Anytime one has an unwavering view that doesn’t ebb and flow with the tides of investment sentiments, the collective view will occasionally converge with it.  Sometimes, it happens in a big way.

So I’ve held this worldview and when the prevailing viewpoint is congruent with mine I, too, feel strange.  The initial feeling when the world seems to agree is one of vindication but, summarily, the contrarian in me feels uncomfortable and leads me toward rigid self-examination.  Okay, I was right but will I continue to be?  If so, why?  Is the data coming out that seems to vindicate these views even accurate?  How to capitalize on the situation from here?  It is not profitable to hold one view forever in spite of the evidence so one needs to constantly question.  The philosophical part of the post is over.  [Continue reading for more stream-of-consciousness.  This is the most fun way to write a blog – get some thoughts out on paper and minimally edit them.  Who was it – ? – Pascal or some prolific writer – who didn’t edit typos because he thought it a waste of time.  I agree to a point, though MS Word sees to it that I have far fewer typos that had I been inscribing this on papyrus several hundred years ago with a feather and charcoal.]

* * * * *

With talk of the Dow headed lower, I will always remember the WSJ headline the day before (or day of) the bottom discussing how the markets could go MUCH lower than they were at the time.  World trade data was terrible.  Unemployment was rising.  One difference between then and now is that it’s a worldwide — or at least multi-country — phenomenon, and the Fed has blown most of its firepower and, more importantly, its credibility, to little effect.  The world is more at the mercy of natural forces rather than some (flawed) idea that fiscal and monetary intervention, poorly conceived, can get us out of any mess.  The can has been kicked as far as it can go and investors know there will have to be real losses…and that governments really can’t do much about it other than let it play out.  Sure, there will be efforts to do one thing or another and on some level they might be successful.  But ultimately debt has to be paid down and that means lower growth and a slower recovery period than we’ve been used to for several decades.  Bummer, I know.  Grab a drink.

A closing thought I alluded to above: typically when the collective is leaning one way, it may not be the right way to lean.  Is it time to look for opportunities in the ‘it turns out better than everyone thinks’ trade?  Late MIT economist Rudiger Dornbusch said something like, The crisis takes longer than you think, then hits faster than you would have thought.  I would not personally bet on things getting better on a macro basis, but I think individual opportunities are clearly out there.

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The Great Equalizer

12 Sep

The financial crisis of the past several years has had an equalizing effect on the experience of many in the investment industry.  After what’s transpired, a person with five years of experience might rightly be considered to possess similar competencies as someone with twenty-five.  The reason?  The crisis, abrupt market declines and recovery, and ongoing economic and market difficulties have been new to the experience of most current market participants.

The newest industry entrants (the last two to three years) that have just read about in school or saw it happening while they were taking classes and not actually investing others’ money do not count here.  I speak of those that have actually lived through it.  Moreover, those who’ve lived through it and taken time to understand what’s going on in the context of history have benefited the most.  We know similar events have taken place before, just not in most folks’ memories.  And that is the key point.  The same can be said of periods like the Great Depression as well as the go-go market of the 1960s that gave us the market malaise of the 1970s.  Each of these periods was preceded by a market unhinged from value and driven largely by younger folks who had not experienced a serious downturn in their (career) lifetimes.  Until they did.

This experience and historical knowledge is not always helpful, however.  For example, an historical perspective over this period gave me the knowledge that it could get a lot worse.  Yes, the market could have rallied big time (it did) but it could also drop in half over the subsequent several year period, as happened during the Depression.  Instead of falling to 10x normal earnings, it could go well past that and hit 6 times (it didn’t).  So historical perspective could have caused one to be more conservative than was warranted with perfect 20/10 hindsight.

Still, out of this period client interactions have changed, as well as the way portfolios are allocated.  The way an investor should think about longer-term objectives has also been altered.  While modern portfolio theory had largely been discredited before the market declines, it now has less credence in the industry (though it remains in widespread use; the investment and planning industries use it because it offers some degree of concreteness in a world that otherwise lacks concreteness).  But while it’s methodology may aid in allocating portfolios from a top-down perspective, what makes the most sense is not whether a portfolio is mean-variance efficient.  Fundamentals and client goals matter.  It’s not just the frequency of the event that’s important – i.e., that stocks go up over time.  It’s the magnitude – i.e., they can go down 50% the year you need the money.

The Great Equalizer effect of which I write needs qualified.  It has been easy, given the market rally and economic recovery (until recently) that ensued after the depth of the market lows in March 2009, to adopt a ‘bad couple of weeks’ mentality.  Seth Klarman has pointed this out and I agree.  In some ways, people forgot how bad it was in late 2008 and early 2009.  (Memory is extremely short in finance, that’s why we have such frequent cycles.)  The folks still in the game who remember it and stick with their post-crisis philosophical and methodological recalibrations are the ones whom I believe will be the most successful over time.  Yes, stocks will rally from time to time but they can also go down and stay there for an extended period (they just didn’t this time).  And given prevailing valuations the broad indexes are not discounting the double-digit returns of yore, unless we have a larger selloff and start at a lower base.  Mid single-digit returns look most likely here, but so does the possibility of large drawdowns.  Overall, though a well-considered, goal-oriented investment allocation that focuses on base hits is going to be a better approach than something that is trying to catch each wave but risks going out with the tide.

Chinese demand profile and incremental commodity demand

28 May

I wanted to point out a few things about China from Michael Pettis’ early May newsletter. Below are some really eye-popping statistics about China’s demand profile. (Many thanks to Jeremy Grantham, to whom Pettis credits as the original source for the below statistics.)


Share of global GDP

China’s GDP

9.4%

China’s GDP (PPP basis)

13.6%

“The next table lists China’s share of total global demand for a selected list of non-food commodities:

Non-food commodities

Share of global demand

Cement

53.2%

Iron Ore      

47.7%

Coal

46.9%

Steel

45.4%

Lead

44.6%

Zinc

41.3%

Aluminum

40.6%

Copper

38.9%

Nickel

36.3%

Oil

10.3%

“Finally, the same table for food commodities:

Food commodities

Share of global demand

Pigs

46.4%

Eggs

37.2%

Rice

28.1%

Soybeans

24.6%

Wheat

16.6%

Chickens

15.6%

Cattle

9.5%

“What is most noteworthy about these tables, of course, is the disproportion between China’s share of global GDP and China’s commodity consumption.”

Pettis, whose commentary is always original and borderline brilliant, goes on to comment about Chinese investment growth and how re-balancing of the economy in that country (from investment-led demand to consumption-led demand), could have significant effects on non-food commodities (second chart):

“Take iron, for example. If Chinese demand declines by 10%, this would represent a reduction in global demand of nearly 5%. I am not an expert in the commodity markets, but I guess that supply and demand considerations are fairly finely balanced, and a 5% reduction in demand should have significant price repercussions – especially if a material part of Chinese demand represents stockpiling and this stockpiling is reversed.”

Some food (or non-food) for thought.

investors + love = farmland

19 May

As an Iowa native and investor, it’s almost requisite that we follow farmland. About 60% of our farms are owner-operated and over 80% are individual or family organizations. We supply 7% of nation’s food supply with farms that make up over 90% of our land (second only to Nebraska); roughly one-third of the best US farmland is located here. While manufacturing is the largest sector of the Iowa economy, the majority of that is related to food processing and machinery — estimates put the indirect role of agriculture here around 25% of our total economic output. Needless to say, farming in one way or another comprises a large portion of our economic activity and state wealth, not to mention the knock-on effects as incomes in that space move higher.

In the first quarter of the year, farmland was up 16% in the Midwest. At first glance, it appears these increases were justified, since cash rents also gained 16%. Because of this, the price-earnings ratio for farmland was unchanged – which is a good thing given it’s already in the 25-27 range depending on the state. In Iowa, farmland values gained 20% while cash rents grew slightly less at 16%.

Not surprisingly, these year-over-year increases were driven by higher agricultural prices – corn up 50%, soybeans 29%, while milk, hog, and cattle gained at least 20%. Input prices, meanwhile, were up less than 10%, leading to higher profit margins.

We would worry about rising farmland values if bank balance sheets looked stretched, but the average loan-to-deposit ratio was at its lowest level in nearly 15 years (a period over which farmland values are up substantially). In other words, banks have more money to lend; some three-quarters of regional banks have actually lent less than they would like to. The fact that loan demand has actually come down while prices rise bodes well should farm values reverse in sudden fashion. Leverage can be particularly painful on the downside.

So who’s buying? Bankers report that it’s increasingly farmers, rather than investors. It also seems that the number and acreage of farms sold were larger than a year ago. This jibes with our comment in the last post about farmland that farmers know (1) dirt and (2) CDs, or bank certificates of deposit. Given the profile of the incremental farmland buyer, we’re watching CD rates as a leading indicator for farmland values. Should banks begin to pay substantially higher rates on CDs, watch for land values to decline – absent a major change in commodity prices, of course.

Napier comments from Edinburgh

18 May

Russell Napier is a brilliant guy and we love his book Anatomy of the Bear. While he is not always right – no strategist ever is – he has made some great calls with historical precedent to back it up. His recent comments from the 2011 CFA Annual Conference are worth a few minutes of time.

two years and investment professionals’ mindset

17 May

Just returned from the CFA Annual Conference in Edinburgh, Scotland this past week and wanted to get a few thoughts down to maybe crystallize my takeaways. If you’d like a play-by-play, the conference was live-tweeted under @CFAIowa and also the #CFA2011 hashtag. I have found myself returning to these feeds and am likely to reference them several more times as I pen this.

The last conference we attended was 2009, and the world was just six months past a blow-up that brought down Lehman, Bear, and (almost) lots of others. The world had undergone a major shift, a ‘phase transition’. That year, it was as if the attendees were in a dark room, grasping around for the light switch. The various speakers proffered various suggestions on the location of the switch, and attendees were still forming their opinions of what exactly had happened and what was likely to transpire in the future. All we knew at the time was that the market had gained about 50% off the bottom in just two months but it was far from clear whether it was sustainable.

In retrospect, as usual, some forecasters were more right than others and the events since make reflecting on it much easier — had the world collapsed we’d see things much differently today. Instead, equity markets are ahead by double their March 2009 lows and the gains we’ve seen have proven sustainable thus far. In many ways, the light switch has been located.

From the vantage point of 2011, investors seem to have a good grasp of the major (known, large) risks to the world economy. The risks are that are well known today were more or less on the fringe at this time in 2009 – Eurozone economic risks, sovereign credit risks, debt, deficits, over-leveraged consumers, debt-fueled spending, the threat of rising inflation and interest rates, the rise of emerging markets, commodity supply and demand dynamics. Each was more or less reflected to varying degrees in the speeches and seminars this go round. There were a few ‘fringe’ views at the 2011 conference but nothing that was extremely aberrant. (You might have a guy who only likes gold, for example, but even this is almost mainstream today.) Whereas in 2009 the presenters spanned the “31-flavors” gamut, most came in vanilla circa 2011.

I will soon write another post on key takeaways – what might be gleaned from a contrarian viewpoint when ‘everybody knows’ the risks and issues facing investments. I think there are many broader implications for the investment profession as a whole. It seems clear that the powerful ‘institutional imperative’ will impede future performance even though managers, well aware of the potential headwinds facing market valuations and interest rates, believe they should not be 100% invested right now. Just because the risks are apparent doesn’t mean everyone is acting to protect against them. Career risk, or The Risk of Poor Short-Term Performance – a major issue to investment industry credibility – sometimes leads managers do crazy things when viewed from a long-term perspective. Often, ‘what’s right’ is not ‘what’s right now.’

Until next time!

Berkshire Hathaway, Sokol findings

27 Apr

For its ethical precepts, the just-released report on David Sokol’s Lubrizol-related trading is an important read. Reading between the lines, this report sends a clear message: Buffett is pissed. Thankfully, it was released just ahead of the annual meeting this weekend. This ought to free up more time for questions about other matters and I’m very much looking forward to just that.

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