As you read this, you’re most likely more liquid, more scared, and more poor than you were one year ago. Every day brings another bleak headline. At times like this, I remember two pieces of timeless wisdom. The first is from the great Hebrew King Solomon: “This too shall pass.” The second is from the great Trinidadian Billy Ocean: “When the going gets tough, the tough get going.” With this in mind, I present a few principles for 2009:
If like many hedge funds you ended 2008 “only” down 20% while the S&P ended down around 40%, your investors may hate you and you may hate yourself, but both of you should take a minute to consider the mathematics of capital preservation.
Consider two investors at the start of 2008, each with $100 to invest. One invested with you and now has $80, while the other invested in the S&P and now has $60. On December 31, 2008 the first investor takes his $80 and invests it in the S&P, while the second investor holds onto his now-depleted S&P stake. If the S&P returns 8% a year for the next four years, then at the end of the five-year investment period the first investor ends up with $108.84, while the second ends up with $81.63. Not only has the first investor more than recouped his initial losses, but he ends up achieving a 5.7% annual advantage over the second investor for the full five-year period. In other words, your year-one capital preservation heroics have “locked in” an advantage over the passive investor that many active investors would be happy to report (and charge for).
Remind yourself of what both Buffett and Barton Biggs have pointed out, and what macroeconomic prognosticators often forget: a stock market bottom does not occur when terrible economic news turns into good news. It occurs when terrible news turns into less terrible news, which turns into bad news, which turns into OK news. Then force yourself to be intellectually honest. Broadly speaking, either:
1) You think you can call the bottom, the exact moment when the terrible news becomes slightly less terrible. If you think you can do this, ask yourself if you could have predicted the Great Depression stock market bottom of mid-1932, before any economic recovery was in sight (FDR wasn’t even inaugurated until the beginning of 1933); or the UK stock market bottom of Word War II soon after the evacuation of Dunkirk in May 1940, but before the further misery of the Blitz and the loss of Britain’s Asian empire, and way before the U.S. entered the war in December 1941; or the US stock market bottom of WWII in May 1942, almost two years before the so-called “turning point” of D-Day.
2) You don’t think you can call the bottom, you’re willing to sit in cash “until the storm passes,” AND you’re willing to accept a substantial penalty for doing so in terms of future returns.
3) You don’t think you can call the bottom but you’re willing to invest now in what you think are undervalued ideas, AND you’re willing to accept a substantial penalty for doing so in terms of potentially large downside volatility in the near term.
4) You try to split the baby, like Jeremy Grantham, who in a recent Fortune interview said the following:
How bad will you feel if you put in your cash reserves and the market continues to go down? You're going to feel awful. And how will you feel if you don't buy in the cheapest market for 20 years and it runs away and leaves you? Horrible. You have to step your way through so that the regret, which is going to be huge anyway, is about neutral.
Like many value investors, I put myself in the third camp. I believe that today there are billions of dollars on the sidelines for fear of near-term volatility, and those who step into the breach will be rewarded. In order to step into the breach though, your capital must be as permanent as possible - all the way down the line. That means, first of all, that your capital and that of your investors must have a long-term time horizon - at least five years, I’d say. If that’s not true you risk a doubly bad outcome, as your professed serenity about near-term fluctuations melts away at precisely the wrong time to be dumping assets. It also means the securities in which you invest must be in companies that themselves have permanent capital, defined as the ability of the right side of the corporate balance sheet to endure substantial volatility in earnings and asset prices.
If you are reading this, chances are you are very long the dollar - too long, given that “this too shall pass” applies to countries and dominant currencies too. One hundred years ago everyone wanted to be long the British Empire. Two hundred years ago everyone wanted to be long the Napoleonic Empire. Big mistakes in both cases. Those of us who marvel, with barely contained glee, at how so many people could have trusted Bernard Madoff with so much of their money, should pause to consider that we are “trusting” the United States in much the same way. I’m not suggesting our government is a swindler. I am suggesting that a “diversified” portfolio of entirely dollar-based income streams (from stocks, bonds, or wages) is less diversified than you think, just as a Madoff victim whose long monthly statements convinced him he was diversified turned out to be very wrong. In any event, today’s “flight to quality” environment is an opportune time to diversify away from the dollar, as foreign assets are cheaper than they have been on both own-currency and dollar-based terms.
A corollary: today one of the most undervalued assets is expected future inflation. I believe those who protect themselves now will be rewarded. I don’t favor the usual suspects like commodities or shorting treasuries. Rather, I’m trying to invest in companies with high ROEs and low capital requirements, pharmaceuticals like Pfizer (NYSE:PFE) and Sanofi-Aventis (NYSE:SNY) for instance.
That’s how I look at things. The usual disclaimers apply—this is my opinion, not my recommendation. Good luck for a happy and healthy new year.
Disclosure: Long PFE, SNY