Proclamations like ‘The Death of Equities’ usually arrive near the point of maximum pessimism, and when everyone is most bearish it is usually time to take a contrarian stance and buy. However, today - less than 4-years into a historic deleveraging phase* - calls that equities are dead are likely to prove premature. Equities are not ‘dead’ in the sense that they are poised to rally strongly from a contrarian perspective. Rather, equities are simply dying…
Backing out the equity death noise, the goal for the value investor is much the same: find quality companies to hold for an extended period of time that you conclude will produce a solid return. Those that confuse this goal with trying to figure out which major asset class may quake higher, rattle lower, or roll over a cliff are bound to be disappointed.
Fishing For Safety In Stocks
Selected for the Wish List in December 2004, we watched patiently as High Liners’ stock price wallowed in the depths of despair for more than 4-years. During this time we often noted that a falling share price could represent an opportunity, and that we didn’t envision ever removing High Liner from the Wish List. After effectively using its clean balance sheet to acquire key competitors, High Liner’s stock price ‘bottomed’ and its business operations improved during the 2008/09 market meltdown. 7-dividend hikes later, HLF has opened 2012 by hitting new highs.
Another more recent Wish List selection, MOCON Inc., was the sole new company selected for the 2011 Wish List. MOCON had many of the qualities that separate winners from losers in the marketplace: namely a long history of impeccable balance sheet management, a niche leadership position in a growing industry, and 27-years of dividends. MOCON was removed during last year’s sharp rally due to valuation concerns, but remains a potential candidate to purchase on weakness.
These examples are not meant to suggest that finding quality companies at an opportunistic price is easy. It isn’t. Rather, acquiring a good understanding of a business takes time, and finding an attractive point of entry can take years to develop, if ever. One of our nightmares on this front is Tim Horton’s, which is the most attractive Canadian utility that happens to serve coffee instead of electricity to its customers. Since going public in 2006 THI has failed to sport a share price at truly attractive price levels. The wait continues.
Beyond time/value considerations, what also makes catching specific equity stories difficult is the dysfunctional state of the global economy, in particular the madness transpiring in America. To be sure, with much of the developed world infected by the meme that is austerity the good ol’ days would appear to be gone, and yet the U.S. remains a debt-craved lunatic asphyxiated by its exceptionally easy money policies. While the Euro crisis may catch the bulk of the doomsday headlines, the monetary and fiscal quagmires that will eventually consume the U.S. are far more ominous considerations for the investor.
Thinking About 2012
Be it the Euro crisis, China slowdown, or the reawakening of the U.S. debt nightmare (something that does not look likely in coming 12-months), there are no shortage of potential financial monsters lurking in the shadows. Moreover, if looking at debt/anything ratios or menacing worldwide demographic trends, the future is about as bleak a picture that has been painted since the Great Depression. Finally, add to this dismal outlook escalating geopolitical tensions and potential social unrest/conflict as the global economy underperforms...a gasoline soaked tinderbox is the image that springs to mind.
The illusion of recovery hangs in the balance as these issues play out. In the case of the U.S., beyond the possibility of further ‘recovery’ in the coming months, the questions longer-term are daunting. For example, what happens when the Fed tries to deleverage its balance sheet, financial institutions try to rationalize counterparty exposures hidden on their balance sheets, and the U.S. government tries (is forced?) to adopt a balanced budget?
Suffice to say, even if recovery does remain the theme in 2012, with so many macro/event clouds rolling in now is not be the best time to be heavily overweight equities. Along with the event risks, consider P/B statistics and the manipulated trailing P/E figures, both of which are not pricing in ‘death’ as they did before the early 1980s secular bull took hold. Rather, absolute valuation matrixes suggest that equities are only slightly undervalued compared to the historical norm.
As for the one area of the marketplace that says equities are exceptionally undervalued (i.e. Fed/interest rate models), it may be worth remembering why any equity-backed numbered compared to the 10-year Treasury bond look so tantalizing. After all, without direct Fed purchases and recent safe haven flows due to the Euro crisis, what would be the yield on U.S. bonds? Is a negative real return in U.S. Treasury bonds really a sustainable benchmark to compare stocks to?
In short, despite the glimmer of undervaluation, with profound event risks likely to persist for years rather than months, the preferred path is to wait until lightening strikes (and share prices move lower) before increasing your exposure to equities.
Here Comes The Rain Again
The critical question of course is whether efforts by the ECB, BOE, and Fed will work. Can they reinvigorate animal spirits in the face of “credit” and “zero bound money” risk?
Bill Gross, Pimco. January 2012
The ‘critical question’, as Mr. Gross submits, is really not a question at all. Rather, the idea that monetary ‘efforts’ can ‘work’ in boosting animal spirits comments on the dyslexic-like dysfunction in the financial markets. This dysfunction, put simply, is the myopic, repetitive, and downright belligerent belief that the goal of unleashing animal spirits (or risk taking in the marketplace) is a one-way street to recovery. The applicable analogy for this hokum is that of someone planning to burn down their house as respite to a bitter cold, all the while ignoring that once the fire is exhausted they will be left without warmth and shelter.
While Fed machinations not being a sustainable model for growth is hardly a controversial idea, it is nonetheless essential in understanding the markets’ dysfunction. Today the Fed’s overnight lending rate is trapped at zero percent, the 30-year mortgage rate is marred below 4%, and the yield on the 10-year Treasury bond is below 2%. Despite these record low/negative rates of interest the argument is building that more needs to be done by Bernanke and company. The risk-inducing incentives offered by the Fed are clearly producing diminishing returns, so the Fed must do even more!???
“The goal of the purchases will be to drive down interest rates even further from current record-low levels, and, less obviously, to spur confidence that more monetary tools remain to stimulate the economy.” Fed's Latest Easing Could Cost $1 Trillion: Economists CNBC
Remembering that the Fed has been more wrong about the state of the economy and financial markets in recent memory than most on Wall Street, is now really the best time to engineer another wave of asset purchases? Decades of glorious booms and disastrous busts suggest that when monetary intervention is regarded as the prerequisite for reinvigorating economic activity the types of activities produced are hazardous. Will it really be different this time?
Dollar Still King
Last year’s ambiguity to begin the year proved oddly prescient as, despite periods of spectacular volatility, very little transpired in 2011. This said, one plot line did thicken:
“For the moment the world needs the U.S. more than the U.S. needs the rest of the world. This is what 2011, and beyond, is about. Only when this fact changes or investors reacquire an aversion to risk will the outlook for continued recovery materially change.” Jan 12, 11: Another Year of Living Dangerously
The U.S. may be operating from a position of insolvency, and, in many respects, is beyond the point of trying to adopt prudent measures to safeguard the financial system. However, there is no denying that the world still needs the dollar more than the U.S. needs the rest of the world. Despite keeping interest rates at zero percent and purchasing $2+ trillion of Treasury and MBS, the U.S. dollar index is up since March 2008.
This surprising dependence on the dollar should not be confused with confidence in the dollar. Rather, there are steps being slowly undertaken by many nations to get off of the dollar, and as these steps progress limits to monetary adventurism in the U.S. may arise. Gold is also a factor as its presence in central bank coffers is increasingly observed. These trends will remain afoot in 2012 even though no climax looks set to transpire.
Conjecture aside, a steady/strong dollar represents a viable platform for U.S. policy intervention over the short-term, even if pulling such strings adds greatly to the uncertainty over the long-term.
The Great Escape (from the macro)
Clarus Corp. was selected for the 2008 Wish List solely for its attractive balance sheet and its treasure chest of NOLs. We held for Clarus for more than 2-years and made a decent return. Given that Clarus’ had no business operations for more than 7-years before it finally came out its shell, it serves as an excellent, albeit rare, example of how to separate event risk from your individual equity selections. After all, save fraud or a complete blow-up of the U.S. dollar, there is absolutely no event risk in owning a company with no operations.
As for companies that do have operations, during the last 5-years the markets have undergone a fantastic bust and yet companies like High Liner and MOCON never lost money, never stopped paying a dividend, and never had their existence placed into question. The same cannot be said of countless financial stocks, companies that have undue leverage on their balance sheets, and firms that have highly cyclical business tendencies.
While not many stocks offer the type of sleep at night safety that say a High Liner provides (HLF is fairly if not over priced today), there are always diamonds in the rough to search for. Find one or two of these gems per and you will be able to delegate a significant part of your portfolio towards worthwhile ideas. As for any capital leftover after your equity ideas run dry, two decade long themes are still valid today: be mindful of your USD position and carry an exposure to precious metals.
In short, when the match is finally lit and the gasoline soaked tinderbox is set ablaze, no amount of central bank wand waving will be enough to save USD hegemony. The macro outlook is, in a word, ugly. With a future scarred with uncertainty, 2012 is likely to be a lot like 2011: major events will arise and unleash volatility in the marketplace, and investor’s not inclined to gamble on these events must remain focused on specific equity stories.
Disclosure: I have owned High Liner shares for more than 7-years.
* Papers and research covering the ongoing deleveraging crisis.
Working out of debt
McKinsey Quarterly. January 2012
Growth in the Age of Deleveraging
Governor of the Bank of Canada, Mark Carney. December 12, 2011
Boomer Retirement: Headwinds for U.S. Equity Markets?
By Zheng Liu and Mark M. Spiegel. August 22, 2011
Decade of Debt
Reinhart, Kenneth S. Rogoff. April 2011
Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach
Gauti B. Eggertsson (NY Fed) Paul Krugman (Princeton). November 16, 2010
Debt and deleveraging: The global credit bubble and its economic consequences
McKinsey Global Institute, January 2010
U.S. Household Deleveraging and Future Consumption Growth
Reuven Glick and Kevin J. Lansing, FRBSF May 15, 2009