(This article was written last October! Several forecasts has turned out right on the money. The author’s advice still is quite valuable today. –Bob)
By Vitaliy Katsenelson – Re-Blogged From http://www.institutionalinvestor.com/
In my column last Friday, in response to an e-mail I had received from an investor asking “what the fuck” he should do, I promised to explain what we’re doing with our portfolio. I will, but first let me tell you a story. When I was a sophomore in college, I was taking five or six classes and had a full-time job and a full-time (more like overtime) girlfriend. I was approaching finals, I had to study for lots of tests and turn in assignments, and to make matters worse, I had procrastinated until the last minute.
I felt overwhelmed and paralyzed. I whined to my father about my predicament. His answer was simple: Break up my big problems into smaller ones and then figure out how to tackle each of those separately. It worked. I listed every assignment and exam, prioritizing them by due date and importance. Suddenly, my problems, which together looked insurmountable, one by one started to look conquerable. I endured a few sleepless nights, but I turned in every assignment, studied for every test and got decent grades.
Investors need to break up the seemingly overwhelming problem of understanding the global economy and markets into a series of small ones, and that is exactly what we do with our research. The appreciation or depreciation of any stock (or stock market) can be explained mathematically by two variables: earnings and price-earnings ratio. We take all the financial-climate-changing risks I wrote about a few days ago — rising interest rates, Japanese debt, the Chinese bubble, European structural problems — and analyze the impact they have on the Es and P/Es of every stock in our portfolio and any candidate we are considering.
Let me walk you through some practical applications of how we tackle climate-changing risks at my firm.
When China eventually blows up, companies that have exposure to hard commodities, directly or indirectly (think Caterpillar), will see their sales, margins and earnings severely impaired. Their P/Es will deflate as well, as the commodity supercycle that started in the early 2000s comes to an end.
Countries that export a lot of hard commodities to China will feel the aftershock of the Chinese bubble bursting. The obvious ones are the ABCs: Australia, Brazil and Canada. However, if China takes oil prices down with it, then Russia and the Middle East petroleum-exporting mono-economies that have little to offer but oil will suffer. Local and foreign banks that have exposure to those countries and companies that derive significant profits from those markets will likely see their earnings pressured. (German automakers that sell lots of cars to China are a good example.)
Japan is the most indebted first-world nation, but it borrows at rates that would make you think it was the least indebted country. As this party ends, we’ll probably see skyrocketing interest rates in Japan, a depreciating yen, significant Japanese inflation and, most likely, higher interest rates globally. Japan may end up being a wake-up call for debt investors.
The depreciating yen will further stress the Japan-China relationship as it undermines the Chinese low-cost advantage. So paradoxically, on top of inflation, Japan brings a risk of deflation as well. If you own companies that make trinkets, their earnings will be under assault.
Fixed-income investors running from Japanese bonds may find a temporary refuge in U.S. paper (driving our yields lower, at least at first) and in U.S. stocks. But it is hard to look at the future and not bet on significantly higher inflation and rising interest rates down the road.
A side note: Economic instability will likely lead to political instability. We are already seeing some manifestations of this in Russia. Waltzing into Ukraine is Vladimir Putin’s way of redirecting attention from the gradually faltering Russian economy to another shiny object — Ukraine. Just imagine how stable Russia and the Middle East will be if the recent decline in oil prices continues much further. Defense industry stocks may prove to be a good hedge against future global economic weakness.
Inflation and higher interest rates are two different risks, but both cause eventual deflation of P/Es. The impact on high-P/E stocks will be the most pronounced. I am generalizing, but high-P/E growth stocks are trading on expectations of future earnings that are years and years away. Those future earnings brought to the present (discounted) are a lot more valuable in a near-zero interest rate environment than when interest rates are high. Think of high-P/E stocks as long-duration bonds: They get slaughtered when interest rates rise (yes, long-term bonds are not a place to be either). If you are paying for growth, you want to be really sure it comes, because that earnings growth will have to overcome eventual P/E compression.
Higher interest rates will have a significant linear impact on stocks that became bond substitutes. High-quality stocks that were bought indiscriminately for their dividend yield will go through substantial P/E compression. These stocks are purchased today out of desperation. Desperate people are not rational, and the herd mentality runs away with itself. When the herd heads for the exits, you don’t want to be standing in the doorway.
Real estate investment trusts (REITs) and master limited partnerships (MLPs) have a double-linear relationship with interest rates: Their P/Es were inflated because of an insatiable thirst for yield, and their earnings were inflated by low borrowing costs. These companies’ balance sheets consume a lot of debt, and though many of them were able to lock in low borrowing costs for a while, they can’t do so forever. Their earnings will be at risk.
As I write this, I keep thinking about Berkshire Hathaway vice chairman Charlie Munger’s remark at the company’s annual meeting in 2013, commenting on the then-current state of the global economy: “If you’re not confused, you don’t understand things very well.” A year later the state of the world is no clearer. This confusion Munger talked about means that we have very little clarity about the future and that as an investor you should position your portfolio for very different future economies. Inflation? Deflation? Maybe both? Or maybe deflation first and inflation second?
I keep coming back to Japan because it is further along in this experiment than the rest of the world. The Japanese real estate bubble burst, the government leveraged up as the corporate sector deleveraged, interest rates fell to near zero, and the economy stagnated for two decades. Now debt servicing requires a quarter of Japan’s tax receipts, while its interest rates are likely a small fraction of what they are going to be in the future; thus Japan is on the brink of massive inflation.
The U.S. could be on a similar trajectory. Let me explain why.
Government deleveraging follows one of three paths. The most blatant option is outright default, but because the U.S. borrows in its own currency, that will never happen here. (However, in Europe, where individual countries gave the keys to the printing press to the collective, the answer is less clear.) The second choice, austerity, is destimulating and deflationary to the economy in the short run and is unlikely to happen to any significant degree because cost-cutting will cost politicians their jobs. Last, we have the only true weapon government can and will use to deleverage: printing money. Money printing cheapens a currency — in other words, it brings on inflation.
In case of either inflation or deflation, you want to own companies that have pricing power — it will protect their earnings. Those companies will be able to pass higher costs to their customers during a time of inflation and maintain their prices during deflation.
On the one hand, inflation benefits companies with leveraged balance sheets because they’ll be paying off debt with inflated (cheaper) dollars. However, that benefit is offset by the likely higher interest rates these companies will have to pay on newly issued debt. Leverage is extremely dangerous during deflation because debt creates another fixed cost. Costs don’t shrink as fast as nominal revenues, so earnings decline. Therefore, unless your crystal ball is very clear and you have 100 percent certainty that inflation lies ahead, I’d err on the side of owning underleveraged companies rather than ones with significant debt.
A lot of growth that happened since 2000 has taken place at the expense of government balance sheets. It is borrowed, unsustainable growth that will have to be repaid through higher interest rates and rising tax rates, which in turn will work as growth decelerators. This will have several consequences: First, it’s another reason for P/Es to shrink. Second, a lot of companies that are making their forecasts with normal GDP growth as the base for their revenue and earnings projections will likely be disappointed. And last, investors will need to look for companies whose revenues march to their own drummers and are not significantly linked to the health of the global or local economy.
The definition of “dogma” by irrefutable Wikipedia is “a principle or set of principles laid down by an authority as incontrovertibly true.” On the surface this is the most dogmatic columns I have ever written, but that was not my intention. I just laid out an analytical framework, a checklist against which we stress test stocks in our portfolio. Despite my speaking ill of MLPs, we own an MLP. But unlike its comrades, it has a sustainable yield north of 10 percent and, more important, very little debt. Even if economic growth slows down or interest rates go up, the stock will still be undervalued — in other words, it has a significant margin of safety even if the future is less pleasant than the present.
There are five final bits of advice with which I want to leave you: First, step out of your comfort zone