October 18, 2011

Two contrary indicators regarding where the equity markets may go (over the short term!) are worth mentioning.

The first indicator is throughout the recent volatility investors in the US and Canada withdrew $80 Billion more from equity mutual funds in the four months from the market peak of April of this year to August than they did in the five months after the Lehman collapse in September 2008!  Remember that those five months from Oct 2008 to February 2009 represented the greatest buying opportunity in a generation and the prices paid for equities at that time will most probably never be seen again.  So once again, many investors “sold low” and history has proven that the masses never get it right.

The second statistic from this most recent panic is that during August, insiders in the US (company officers and directors) spent even more of their own money buying their stocks than they did at the bottom in March of 2009.   The dollar volume of insider purchases in August (for the US) was $681 million, up 15% from March of 2009. Another class of insiders, including hedge fund managers that own more than 10% of a stock, were net buyers in August of almost $1Billion!

Insiders in the US are required to hold the stock they purchase for 6 months, based on SEC rules, so market timing is likely not the objective – these buyers are acting like value managers and buying quality shares cheaply.  When a director of Exxon Mobil buys $700,000, a director of Berkshire Hathaway invests $843,300 and a Merck CEO spends a $1.5 million at a time when the average investor is scrambling to get out – somebody is trying to tell us something.

Significant market bottoms typically have less to do with market fundamentals than the magnitude of public panic.  The greater the fear – the closer we are to the bottom.

Third Quarter 2011 Review

The high volatility of equity markets resulted in poor investment performance this past quarter to Sept 30th, in Canada and most global markets.   The global economy is going through major structural change and its taking time.  With all the negative economic news we are hearing it was important to note the comments from investment veterans on the economy, what they feel is happening and thoughts on future prospects.

“This country comes back; we came back from Pearl Harbour and we’re coming back now.”
Warren Buffett (Charlie Rose Show – Friday September 30, 2011)

“You can’t count out the largest, the most innovative economy in the world. The US has the economic, political and legal constitution to solve issues. Those factors aren’t apparent in the Far East, they aren’t apparent in China.”
Jim Leech, CEO, Ontario Teachers’ Pension Plan

This report draws from two sources; one is a 30 minute interview with Warren Buffett on PBS from Friday, September 30, 2011. The other is a September panel discussion with the title “The End of America?” moderated by CNBC’s Maria Bartiromo, and featuring four participants with long experience and outstanding track records:

Larry Fink, CEO of Blackrock, the world’s largest asset manager
Pierre Lagrange, a highly respected hedge fund manager based in London
Jim Leech, head of Ontario Teachers’ Pension Plan, a leader among global institutional investors
Meredith Whitney, an investment analyst who was among the first to identify the looming problems for US banks

Before focusing on the themes emerging from Buffett’s interview and the panel discussion, here’s a recap of the last 90 days.

Market performance in the third quarter

This has been a year of contrasts, starting with a first quarter that saw strong increases in Canada and the US, followed by a second quarter in which the Canadian market gave those gains back.  The third quarter was nasty, with extreme volatility and the sharpest decline since the first quarter of 2009 when we were in the throes of the global financial crisis. The main drivers of the last quarter’s decline were sovereign debt worries in Europe; and a dramatic downgrading of growth forecasts for the global economy, with a slowdown in China and mounting talk of a double-dip recession fueling anxiety.
Below are results for key markets. These are in local currencies so that the effects of swings in the dollar are not reflected here.

So that’s what’s behind us; the key question is what’s ahead. Four themes emerged from Warren Buffett’s interview and the September panel discussion. The real challenges facing the US and Europe, confidence in America’s ability to respond to those challenges, the cost of risk avoidance in investing, and the opportunities for solid companies in the period ahead.

Theme one: Challenges for Western economies

The first theme relates to some of the troubling issues facing the United States and Europe.  None of the experts’ sugar coated the real challenges ahead.
Warren Buffett on the challenges for Europe:
“It was clear well over a year ago that we were headed towards a cliff, (Europe) tried a grand experiment where the imperfections in it are becoming manifest and the numbers are big. The solvency of the banks is intertwined with the solvency of sovereigns and vice versa, while they melded the currency for 17 countries, they didn’t meld the culture, they didn’t meld the fiscal policy.”

Jim Leech on dealing with uncertainty:
“It’s tough to know where to have conviction in this market. In my lifetime, never have we been so vulnerable to the whims of policymakers in the US and in Europe and nobody has figured out where the consensus is and where they’re going, they’re not united.”

Larry Fink on the role of government:

“I don’t think this environment is any different than the 1970s. In the 1970s, the United States was worried about Japan; we really questioned the vitality of this country. We were questioning the kinds of things we were manufacturing. We had Watergate, the oil crisis, and during those ten years the S & P was up 1.5% a year and yet corporate earnings were up 12% a year during those ten years. The same thing is going on now where we’re seeing earnings growth, but we’re obviously seeing a flat market and a lot of it has to do with the uncertainty around government, very similar to the 1970s. As investors in the 1980′s and 1990′s and the first part of this past decade, government was not part of our thought process and now we’re trying to get rebalanced; today we don’t even know what the foundation is.”

Meredith Whitney on US housing:
“What really powered the US economy for the past 20 years was housing; the biggest structural unemployment problems are in those states like California and Florida that were wed to housing. Housing’s not coming back and it’s hard to imagine housing becoming a driver of the US economy going forward.”

Theme Two: The end of America … or a new beginning?

Despite the issues facing it, there was broad consensus about America’s ability to make the changes needed to compete.

Warren Buffett on a double-dip recession:
“I don’t buy that we’re going into another recession. I’m looking at 70 plus companies, they’re not galloping but there has been no downturn except for construction, which is on its rear.  We have a wonderful economy in the US … this country comes back, it came back from Pearl Harbour and it’s coming back now.”

Jim Leech on why the US will adapt:
“When I got this topic I sat down and said “maybe America is in its denouement.”
“And then you sit back and look on a relative basis and say “no, you can’t count out the largest, the most innovative economy in the world.” The US has the economic, the political and the legal constitution to have the flexibility to solve issues.”
“Those factors aren’t apparent in the Far East, they aren’t apparent in China, we don’t have a democratic government in China, and we’re not sure how the laws work. I think it would be foolish to go rushing off thinking the solution is totally in China and India.”

Larry Fink on opportunities for US companies:
“Today we have opportunities that our corporations never had: At a time when our country is not doing as well, our corporations are doing quite well by building and manufacturing products, selling products to the emerging world. People forget that we are still the largest exporter in the world, we just happen to be the largest importer in the world by a little more.”
“And so having a stronger world actually is stabilizing this economy, it’s not hurting this economy, it’s providing the engine for stronger corporate growth; in most cases when selling products overseas creates jobs here too, and it is a myth that all of these jobs are being exported overseas.”

Meredith Whitney on emerging markets within America:
“You have incredible opportunities that are created outside the US that actually help the US get out of its morass …”
Every generation the US recreates itself economically; we’re doing that now, even though it’s a painful process. If you look at the strength in America, agricultural rich states, what I call the emerging markets of the US, which also have the cleanest balance sheets, you have 22% plus growth dynamics.. What they’re really doing now is attracting businesses, attracting jobs; you’ve got incredible job opportunities, growth within these markets.”

Theme three: Understanding the price of avoiding risk

One topic that got a number of comments was risk avoidance by waiting the volatility out in fixed income investments as the paramount objective for many investors.

Larry Fink on the biggest risk for investors:
“I would avoid 2% treasuries (US Government Bonds), other than fear it’s very hard to make a living earning 2%.”
“So if I had to look where to invest I would own a core amount of treasuries just for liquidity purposes, and I would be looking towards dividend stocks. I would be looking towards credit opportunities; especially with the European banks selling assets there are going to be some great credit opportunities for investors in Europe. The greatest worry I have is under-investing and destroying your foundation, and I think that will be the greatest risk in the next few years.”

Pierre Lagrange on being ruled by fear:
“There are quite a few sectors like the Swiss franc that make no sense where you’re only there because you’re scared of everything else and that always backfires.”

Theme four: Opportunities in global markets

Another area on which experts agreed was that valuations make US and European stocks exceptionally attractive.

Warren Buffett on buying back Berkshire shares:
“When we buy back our own stock, we are intensifying our interest in mostly American companies, Each shareholder will own a greater percentage of Burlington Northern, a greater percentage of GEICO.”

Pierre Lagrange on the upside for European companies:
“Europe is making adjustments at the political level structurally which is very good. What ‘s less accepted is the return on capital employed is really very strong.”
“Since 2008,(companies) have really had the license not to spend money. You have had an extraordinary drive to productivity increases and cost rationalization, so we have a lot of companies which have an extraordinary operating leverage. Now, in some areas of the most cyclical nature it is going to be eaten away by raw material increases, but in other areas you are going to be very strongly surprised positively by the earnings of these companies which is sort of defying expectations in quite a few industrial and consumer stocks.”

Larry Fink on European multinationals:
“We’re of the view that European companies are probably a good place to invest; they’re benefiting like US companies, the Siemens, the Nestles; we’re talking about companies with incredibly low valuations now that are benefiting from the world. They’re being harmed right now because of the instability in Europe but I do believe that over a longer cycle you will benefit from owning those companies.”
“Investors worldwide are diversifying: I think that is one thing we have to accept as a nation, the world going forward because of the successes of South America and China and India, the world has a greater ability to diversify than ever before. There’s going to be a bias towards more global investing, less dollar oriented investing.”

Jim Leech on investing in Asia:
“The rise of Asia and the east has helped us a lot in the last number of years and it will continue to grow; but it’s not a place to go rushing into right now. There has to be fundamental changes in their political situation and their legal regime before you can feel comfortable putting a lot of money on the ground there. Doing it from afar is a lot easier.”

What this means to you

The key points that emerged from Warren Buffet’s interview and the panel reinforced the conversations I have been having with clients over the past year. Clearly, we should be cautious given the policy challenges ahead, but for those investors who need growth to achieve their long term goals, we also need to take a longer view on great businesses available today at inexpensive prices.
The panel’s consensus that the best opportunities are in solid, high quality multinationals that pay substantial dividends is one that I hold as well. I also subscribe to Larry Fink’s suggestion that for investors with cash on the sidelines, now is the time to start putting some of that money to work; planning to do this in stages over the period ahead.
One final point pertains to anyone who doubts America’s ability to compete. Each year, Britain’s Financial Times ranks universities around the globe on quality and reputation. In its last ranking, the U.S. had each of the top 5 and 15 of the top 20 of the world’s universities. For all of its challenges, the best and the brightest talent is still clamouring to come to the U.S. And that gives us confidence about America’s ability to do what it takes to compete and to maintain its global lead.

The links below are to the video of Warren Buffett’s interview and the panel discussion.

Warren Buffett inteview:
September panel:

US National Debt

This article by John Gordon, a respected Wall Street Journal author will give you an excellent perspective of the US National Debt.   He compares the debt to the US Gross Domestic Product (GDP = Output) much like an individuals’ debt needs to be compared to their income to be relevant.  His key point is that the current debt could be brought back in line with historical norms with no spending cuts but with growth in US GDP similar to what the US experiences in the 60’s.