8 July 2010
BIG PICTURE - Today, the economic news is scary and investor sentiment is awful. Therefore, if you are a long-term investor, this is the time to be greedy. Remember, when it comes to investing, nervousness is your friend, comfort your enemy.
There can be no doubt that the developed world faces some serious funding problems and yes, parts of Europe are in trouble. However, this does not mean that the long-term outlook for all businesses is dire. Quite the contrary; several companies are announcing superb operating results and they are trading at reasonable valuations. And over time, the market will surely recognise the expanding earnings of these businesses.
It is worth noting that a stock is a claim on the long-term cash flow of a company and as long as the underlying earnings are rising, the price of the stock will eventually reflect this reality. At least this is how the financial markets have worked since the beginning of time and there is no reason to expect a different outcome in the future. Accordingly, despite the exaggerated market volatility, we are staying faithful to the vast majority of the companies in our portfolio.
Now, given the state of the developed world, we are convinced that deficit-spending, quantitative easing and monetary inflation will intensify over the following years. Needless to say, these endeavours will further diminish the purchasing power of each unit of money, thereby causing the general price level to escalate. Under this scenario, a steadily growing earnings stream from sound companies should provide better investment results than the fixed income stream provided by cash or debt instruments.
Let there be no doubt, all the stimulus packages announced over the past two years are highly inflationary and throughout history, fiscal deficit-spending has always been followed by higher taxation. After all, governments do not earn any money from their own productive efforts. Instead, all their spending efforts are ultimately financed by the public. In order to fund the increase in spending, occasionally the governments raise the tax level but more often than not, they levy the most insidious form of taxation - inflation. The reason governments choose the inflation tax is due to the simple reason that this form of taxation is covert and does not result in widespread resentment.
Today, politicians are running monstrous deficits and they are inflating the money-stock like there is no tomorrow. Unfortunately, without realising the longer-term ramifications of these bailouts, the short-term oriented masses are applauding this mindless inflation. Regardless of the consensus view, it is clear to us that under the guise of 'stimulus', the policymakers are in fact confiscating private-sector wealth and steering the global economic ship towards Inflationville. Finally, it goes without saying that this reckless inflation of the money-supply is disastrous for those who have their nest eggs in cash or fixed income assets. Allow us to explain:
At the time of writing, the yield available on short-term cash is near-zero and a 30-year loan to the US government provides an annual yield of 4%. Now, although it is true that both cash and Treasury Bonds are 'risk-free' assets (they guarantee the return of capital in nominal terms), in an inflationary environment, they are not viable long-term investments.
For starters, cash and fixed income investments are vulnerable to sudden currency debasement. More importantly however, high inflation poses serious problems for money lenders (bondholders). When the value of a currency deteriorates year after year, a security with income and principal repayments denominated in that currency is not going to be a star performer. Surely, you do not need to be a brain surgeon to figure this one out.
During an inflationary era, instead of cash and fixed income securities, what you want is an asset which will either benefit from currency deterioration or increase its earnings yield so that you can at least maintain your purchasing power. Hard assets (precious metals and energy) fall into the first category whereas companies with the ability to raise prices come under the second. Furthermore, it is our contention that over the next decade, businesses which are not capital intensive and still able to generate high returns on invested capital will provide the best growth.
Bearing in mind the above, we have invested our equity portfolio in world-class businesses across a wide spectrum of sectors. At present, roughly 30% of our capital is allocated to various energy companies and we also have exposure to precious metals miners, healthcare firms, retailers, industrial manufacturers and other businesses with favourable long-term economics. Figure 1 provides a snapshot of our equity portfolio and confirms that on a weighted basis, our companies are trading at less than ten times earnings. This represents a 39% valuation discount compared to the S&P500 Index. Moreover, as you can see, our equity portfolio is projected to produce 5-year earnings growth of 14.43% per annum, which is 1.54 times the 5-year projected earnings growth for the S&P500 Index. Last but not least, Figure 1 reveals that our companies generate a higher return on assets than the S&P500 Index; a major plus in this inflationary environment.
Figure 1: Fundamentals of our equity portfolio
In summary, despite the prospects of superior earnings growth, our equity portfolio is currently trading at a significant valuation discount when compared to the broad market. Therefore, we firmly believe that our deeply undervalued holdings are likely to outperform the broad market over the following years.
Apart from running our equity portfolio, for our smaller accounts, we also manage a fund portfolio whereby we allocate capital to our preferred investment themes via the best externally managed funds. At present, our fund portfolio is invested in our favoured macro-economic themes such as developing-Asia (China, India and Vietnam), precious metals mining stocks and energy (crude oil producers and renewable energy).
In our view, the fast-growing economies in the East are likely to provide leadership and their stock markets should produce stellar growth. Amongst our preferred Asian markets, both China and Vietnam are currently on the bargain table and long-term investors should consider adding to their positions. Once the ongoing consolidation has run its course, both these stock markets are likely to appreciate, perhaps significantly.
Look. We are aware that the global economy faces many challenges and investor-sentiment is horrendous. Furthermore, we also recognise the fact that many prominent pundits are now calling for a chilling deflationary winter. According to the bearish camp, stock markets are on the verge of a collapse, paper money is about to disappear and entire nations are almost insolvent.
As much as we sympathise with these dire forecasts, we continue to believe that we are in a multi-year bull-market. In our opinion, when it comes to investing, monetary policy is the single most important factor and as long as interest-rates remain suppressed, asset prices are likely to continue their north-bound journey. As sure as night follows day, at some point in the future, interest-rates will rise and the monetary backdrop will (once again) become hostile towards 'risky' assets. When that happens, we will amend our investment strategy and re-position our clients' capital. However, for the next several months at least, we expect the monetary conditions to remain asset-friendly.
Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription from www.purusaxena.com.
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Puru Saxena is the founder of Puru Saxena Limited, his Hong Kong based firm which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs.
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