Nobel Prize-winning Economist Paul Krugman is continuing to say that the U.S. needs to spend more — not undertake austerity measures — to get out of its economic malaise. Krugman tells CBS This Morning that European countries now undertaking austerity measures are showing how austerity in such situations makes the economy worse without even making much progress on decreasing deficits, because austerity causes growth and revenue to shrink. “Austerity later,” he says. “Austerity when the economy has recovered — but not now.” He says it could take seven years for the economy to return to form if the U.S. continues its current tact, but just a year-and-a-half if it follows his advice, which includes more quantitative easing and raising permissible inflation expectations to 3% or 4%.
Monthly Archives: April 2012
Hedge fund guru Barton Biggs is expecting a few weeks’ worth of weakness for the stock market, thanks to lingering trouble in Europe and a slowing economy in the U.S.
“I don’t think that this correction we’re in is quite over yet,” Biggs recently said on Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays. “I just don’t think it’s gone far enough. Europe is still a shipwreck, and the U.S. economy has drifted into this soft patch.”
Biggs says he’s taken short positions on the German and French stock markets, but says he doesn’t think the U.S. will have a double-dip recession. He’s heavily invested in technology stocks, and also owns oil service and industrial machinery stocks. And he’s maintaining his positions in China, he adds.
In his latest quarterly letter, GMO’s Jeremy Grantham offers some very interesting data on the disconnect between the stock market on one hand, and the economy and “fair value” of the stock market on the other.
“This difference is massive — two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend,” Grantham writes in the letter, which is available on GMO’s web site. “The market’s actual price — brought to us by the workings of wild and wooly individuals — is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!”
Grantham says the biggest reason for this disconnect is career risk for professional investors. Being wrong on your own can be career suicide, he says, so most of the pros “go with the flow”; that way, even if they are wrong, they can say that they weren’t alone. And that creates herding and momentum, which drive markets far out of whack with economic and corporate realities.
Grantham talks about how his firm has tried to battle that tendency, and offers some tips for how to go against the flow: “You apparently can survive betting against bull market irrationality if you meet three conditions,” he says. “First, you must allow a generous Ben Graham-like ‘margin of safety’ and wait for a real outlier before you make a big bet. Second, you must try to stay reasonably diversified. Third, you must never use leverage.”
“Because asset class selection packs a more deadly punch in the career and business risk game,” he adds, “the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level.”
Grantham’s colleague, Ben Inker, also offers GMO’s take on the current market as part of the quarterly letter. “Today, stocks are expensive relative to our estimate of long-term fair value,” Inker says. “The trouble is, so are bonds and cash. If everything was guaranteed to revert to the mean over 7 years, we would hold equity-heavy portfolios, because the gap between stocks and either bonds or cash is wider than normal. But we don’t know that it will take 7 years. Because cash and (most) bonds have a shorter duration with regard to changes in their discount rate than stocks do, fast reversion would lead to smaller losses for them than for equities.”
With that in mind, GMO is a little lighter on stocks than their long-term projections would warrant. Inker says GMO “around 63% to 64% in equities for a portfolio managed against a 65% equities/35% bonds benchmark and 48% to 58% in equities for absolute return oriented portfolios, depending on their aggressiveness and opportunity set.” The firm sees little to like in the bond market, “leaving us with significant holdings of cash and ‘other.'”
PIMCO’s Mohamed El-Erian says that the U.S. economy is having trouble gaining traction, as evidenced by the latest GDP report. El-Erian tells Bloomberg that in addition to the headline growth number being lower expected, the drivers behind that growth were cause for concern. Consumer spending increased, he noted, but the personal savings rate declined, and that trend isn’t sustainable. He says that business investment is needed to drive the economy, and that wasn’t strong in the first quarter. There’s a “tug-of-war” going on between strong companies that are doing well, and macroeconomic headwinds, he says, and that is causing the lack of business spending. He also talks about the types of stocks he thinks are attractive right now.
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 Warren Buffett-inspired strategy, which has averaged annual returns of 6.3% since its December 2003 inception vs. 3.4% for the S&P 500. Below is an excerpt from the newsletter, along with several top-scoring stock ideas from the Buffett-based investment strategy.
Taken from the April 27, 2012 issue of The Validea Hot List
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the “Oracle of Omaha” has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren’s ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company’s fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand — food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers — those on a company’s balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company’s EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company’s long-term earnings history is solid).
Another part of Buffett’s conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a “durable competitive advantage”. Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett’s approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm’s management is by looking at how the it spends the company’s retained earnings — that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company’s earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself — in other words, how well management is using retained earnings to increase shareholders’ wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we’ve covered so far all are used to identify “Buffett-type” stocks. But there’s a second critical part to Buffett’s analysis: price — can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company’s initial expected yield to the long-term treasury yield. (If it’s not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company’s earnings and stock’s rate of return will be 10 years from now. One method involves using the firm’s historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock’s scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company’s earnings will be in 10 years may seem to run counter to Buffett’s nonspeculative ways. But while using these methods to predict a company’s earnings for the next 10 years in her book, Mary Buffett notes: “In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders’ equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made.”
My Buffett-based 10-stock portfolio wasn’t one of my original portfolios, instead coming online in late 2003. Since then, it’s returned 62.1%, more than twice what the S&P 500 has gained (28.8%; all figures through April 23).
The portfolio has been a very strong performer over the past few years. In 2009, it had a banner year, gaining 50.3% and more than doubling the S&P. It lagged the index in 2010, gaining just 6.3%, but bounced back strong in 2011, gaining 10.2% while the broader market was flat. This year, it’s outperforming again, having gained 11.7% thus far vs. 8.7% for the S&P.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors’ eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world’s greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here’s a look at my Buffett portfolio’s current holdings. It’s an interesting group, and some of the holdings might not seem like “Buffett-type” plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
The TJX Companies, Inc. (TJX)
Oracle Corporation (ORCL)
PetMed Express, Inc. (PETS)
Monster Beverage Corp. (MNST)
Raven Industries (RAVN)
Bio-Reference Laboratories Inc. (BRLI)
Rollins Inc. (ROL)
World Acceptance Corp. (WRLD)
Coach, Inc. (COH)
Infosys Ltd (INFY)
Barry Ritholtz of FusionIQ and The Big Picture blog says that, despite what the doom and gloom crowd says, America is not in decline. Ritholtz tells Yahoo! Finance’s Daily Ticker that “there’s a tendency for people to extrapolate the most recent experience out to infinity”, which is what many have done in expecting that the U.S.’s future will be bleak. He says that investors have to have an ability to “look over the next valley to see what’s on the other side”. He thinks the other side is looking good, citing developments in Silicon Valley as evidence. He also talks about why he thinks the U.S. is different than Japan, and won’t suffer the sort of post-bubble long-term malaise that Japan experienced.
Templeton Asset Management’s Mark Mobius says he is upping his exposure to European stocks, despite the continent’s lingering debt woes.
“The stocks in the European countries have gone down excessively as a result of the bad news emanating from this crisis and we find good investment opportunities at bargain price and we are increasing the purchases of these stocks,” Mobius says, according to Bloomberg.
Mobius adds that “we don’t think the crisis will last forever and the European economies will recover nicely, there will be much more fiscal disciple in one year or two”. He says he’s buying consumer-oriented stocks, and is focusing on eastern Europe.