Buffett Still Worried on Inflation

Warren Buffett says he’s still worried about inflation, and says, contrary to what many believe, inflation can occur even if the economy is operating with significant excess capacity.

“I don’t think there could be a better Fed chairman [than Ben Bernanke], but I still worry about inflation,” Buffett tells CNBC. “He didn’t talk about this the other day, but there’s a lot of people who take the approach that because there’s excess capacity in the United States industry that you can’t have inflation because it won’t get tight.  But I can tell you that in the businesses we’re in [at Berkshire Hathaway], plenty of them have a lot of excess capacity still. But if we get enough commodity price increases, we raise our prices even though business is not good.”

Buffett, who has expressed concern over inflation for a while now, says one example is the carpet industry, where profits have been poor.

U.S. to Get Younger — and Older — over Next Decade

In his latest MarketWatch column, Mark Hulbert takes a look at some interesting demographic trends and predictions that could impact stock market moves over the next decade.

“For years now, there has been a drumbeat from economists about the increasing proportion of the U.S. population that is in or approaching retirement,” Hulbert writes. And that is indeed a powerful demographic trend. “But the increasing proportion of the population in the below-15 cohort is a powerful trend as well, and it will have dramatic effects on the long-term health of the U.S. economy.”

Using data from Ned Davis Research, Hulbert says that, contrary to what many assume, by 2020 a greater portion of the U.S. population will be under 15 than will be under 15 in China. And the U.S. is also projected to have a higher percentage in the under-15 bracket than most European and other Asian countries. But while the over-65 and under-15 cohorts will be expanding in the U.S., the portion of those who fall in between will be shrinking, according to Davis’ projections.

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The O’Shaughnessy Method: Growth and Value

Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the James O’Shaughnessy-inspired strategy, which has averaged 10.8% annualized returns since its inception nearly eight years ago, over a period in which the S&P 500 has returned 4% per year. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas from the O’Shaughnessy-based investment strategy.

Taken from the April 29, 2011 issue of The Validea Hot List

Guru Spotlight: James O’Shaughnessy

To say that James O’Shaughnessy has written the book on quantitative investing strategies might be an exaggeration — but not much of one. Over the years, O’Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor’s Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.

In addition to finding out how certain strategies had performed in terms of returns over the long term, O’Shaughnessy’s study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns — what he called his “United Cornerstone” strategy.

The United Cornerstone approach, the basis for my O’Shaughnessy-based Guru Strategy, is actually a combination of two separate models that O’Shaughnessy tested, one growth-focused and one value-focused. His growth method — “Cornerstone Growth” — produced better returns than his “Cornerstone Value” approach, and was a little more risky. The Cornerstone Value strategy, meanwhile, produced returns that were a bit lower, but with less volatility. Together, they formed an exceptional one-two punch, averaging a compound return of 17.1 percent from 1954 through 1996, easily beating the S&P 500s 11.5 percent compound return during that time while maintaining relatively low levels of risk.

That 5.6 percent spread is enormous when compounded over 42 years: If you’d invested $10,000 using the United Cornerstone approach on the first day of the period covered by O’Shaughnessy’s study, you’d have had almost $7.6 million by the end of 1996 — more than $6.6 million more than you’d have ended up with if you’d invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not — as efficient market believers suggest — move in a “random walk,” but instead, as O’Shaughnessy writes, with a “purposeful stride.”

Two-In-One

Let’s start with O’Shaughnessy’s value stock strategy. His Cornerstone Value approach targeted “market leaders” — large, well-known firms with sales well above those of the average company — because he found that these firms’ stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch — should hold some value stocks.

To find these firms, O’Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.

Size and market position weren’t enough to make a value stock attractive for O’Shaughnessy, however. Another key factor that was a great predictor of a stock’s future, he found, was cash flow. My O’Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.

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Ritholtz High on U.S. Stocks — For Now

Barry Ritholtz of FusionIQ and The Big Picture blog says he’s 90% long on stocks right now, mostly in the U.S. Ritholtz tells CNBC that a lot of his optimism is an “opportunistic trade”. He thinks a major correction is coming sometime in the future, but he says he doesn’t see evidence that it’s coming right now.

Buffett-Type Picks from North of the Border

In his latest “Number Cruncher” column for Canada’s Globe and Mail, John Heinzl takes a look at some Warren Buffett-type stocks, with help from Validea CEO John Reese’s Buffett-based Guru Strategy.

“Unfortunately, Mr. Buffett wasn’t available for our little stock-picking exercise. But the folks at Validea Canada have developed a screen that emulates the Oracle of Omaha’s methods — without all the corny jokes and grandfatherly advice,” Heinzl writes.

Heinzl lists the ten Canada-traded stocks that get the highest marks from Reese’s Buffett-based approach, which looks for qualities like persistent earnings growth over the past decade; low debt; and high returns on equity and capital. Among the top scorers are convenience store and gas station operator Alimentation Couche-Tard, Canadian Western Bank, and Canadian National Railway.

Heinzl also takes a look at some of the broader, non-quantitative parts of Buffett’s strategy. “Mr. Buffett doesn’t try to capitalize on day-to-day price fluctuations, but instead focuses on the company’s business,” he notes. “He looks for companies with strong, long-term track records, and tries to buy them at a ‘fair’ price.”

Grantham: World in Midst of Huge Commodities “Paradigm Shift”

GMO’s Jeremy Grantham says that the world is in the midst of a “paradigm shift”, one that involves a skyrocketing population and dwindling resources. And, if we don’t act soon, the shift will leave us in serious trouble.

“Accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources: after 100 hundred years or more of price declines, they are now rising, and in the last 8 years have undone, remarkably, the effects of the last 100-year decline!” Grantham says in his latest quarterly letter. “Statistically, also, the level of price rises makes it extremely unlikely that the old trend is still in place.  If I am right, we are now entering a period in which, like it or not, we must finally follow President Carter’s advice to develop a thoughtful energy policy and give up our carefree and careless ways with resources.  The quicker we do this, the lower the cost will be.” (Grantham’s paper can be accessed through GMO’s web site.)

Grantham lays out his case in a lengthy paper (19 pages). Here are some of the key points:

  • The exponential increase in world population has “eaten rapidly into our finite resources of hydrocarbons and metals, fertilizer, available land, and water”;
  • Until 2002, the  previous 100 or so years had seen commodity prices (using an equally-weighted index of 33 commodities) decline by an average of 1.2% per year, as “the undeniable law of diminishing returns was overcome by technological progress”;

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Case, Shiller Discuss Housing Market Concerns

Karl Case says that “in a sense” the housing market has already had a double-dip downturn. Case and Robert Shiller, the co-creators of the S&P/Case-Shiller Home Price Indices, tell Bloomberg why the housing market continues to struggle, and what is needed for it to come back.