Fiscal cliff, hyperinflation, recession, implosion of the European Union, breakup of the Euro, the Asians will stop buying the US dollar, interest rates will skyrocket and the US dollar will collapse… Have you heard enough? Yet, the market continues to climb the “walls of worry”.
Can we make sense out of the ongoing “Crises”?
2012 has been pretty eventful up to now. Between the European crisis, the weak economic recovery in the US, the slowdown of the Chinese economy and the upcoming US presidential election, the global economic environment is anything but “normal”. In Quebec, it has been even more interesting with the new minority PQ government and the Charbonneau commission inquiry but we digress.
However, this process could take a period of time, the length of which depends on the courage of the governments in place and its leaders, especially in a democracy. As investors, we should be aware of the reality we are facing:
Massive government intervention has become the rule rather than the exception. Central banks have used monetary tools available to them to manipulate financial markets, creating an environment of artificially low interest rates. As we have said before, we don’t know how long it is going to last but we sense that it might last longer than most people expect.
The economic problems of the world are, in theory, not terribly complicated. After a long period of prosperity, optimism prevails, people and businesses tend to borrow excessively because assets prices and salaries keep rising and everyone is making money. Then, the excess demand for loans begins to push interest rates higher and eventually, the initial cheap and abundant financing dries up, asset prices start plummeting, leaving the financiers and their customers with huge amounts of bad debt.
Normally, bad businesses would fail, bad debts would get liquidated, bond and stock investors would lose money and a renewed sense of caution would pervade the business landscape. Eventually, asset prices would get so cheap that good and stable businesses and investors would start buying them, new businesses would be born, become more profitable and the world would return to higher employment and higher equity prices for the survivors.
- No politician will choose to inflict more pain in terms of business failures, higher unemployment rates and big social spending cuts if they want to be elected or re-elected;
- Big money and lobbyists play a big role in influencing government decisions in their favor: just look at the minimal loss of net worth and jobs by those at the top of society as well as very little prison terms for those who committed fraud or speculated wildly with depositor or customer funds;
History has shown that since lack of courage is more the norm rather than exception, most politicians and central bankers will try to inflate the problems away using the combination of 3 methods: debt restructuring, debt forgiveness and money printing. Higher inflation would be expected. Under such a scenario, common stocks should perform better than bonds.
While we should not be oblivious to the world, we don’t think any large scale changes will be forthcoming and any course of action will result in neither much better nor much worse than what we are seeing today. Notwithstanding, our job is to try and find good businesses having reasonable margins of safety and trading at a big discount during troubled times. If it turns out that times do get better, it’s a wonderful situation. If times get worse, the margin of safety will hopefully protect us enough to avoid large losses.
Most importantly, in our profession, is the understanding of the risks we take when buying a business. We don’t want to assume large risks, whether they are related to the company specifically or macro-economically. Diversification and asset allocation are both integral parts of our strategy when we help you determine your investment objectives. It would be great if we knew what the GDP growth rate and interest rate level would be in the next 6 months or a year. Unfortunately, we don’t have that insight and neither does anybody else for that matter. Forecasting is fun to listen to when the consequences of being wrong are mostly irrelevant, like the weather. For people in that business, we have one piece of advice: forecast many times, you’ll be right more often.
How many stocks should be included in an optimal portfolio?
Unfortunately, there is no magical number. There are multiple ways to get to heaven. Some successful managers own 150 companies and some 20. However, the central tenets underlying the strategy are similar:
- Margin of safety: how much do we lose if we are wrong?
- The market is there to provide us with opportunities and not guide us in deciding what to do.
- Risk is anything that can cause a permanent impairment of capital while volatility (fluctuations) is our friend, not our enemy.
- Do not fall in love with any investments.
- Analyze, analyze and then analyze some more.
We welcome your comments.
The Claret Team