We live in interesting times: The global sovereign debt crisis is having a drastic impact on the flow of capital and is challenging many of the beliefs surrounding valuation methods and monetary policy that have driven our global economy to its current position. To help us establish a thesis that can enable us to increase our wealth during this transitory period, we will first need to identify the flaws in current valuation methods, and then establish a new means by which we can value stocks in consideration of the identified flaws.
First, the traditional method of valuing risk -- the capital asset pricing model (CAPM)-- needs to be re-considered. CAPM assumes that government-issued bonds are risk-free; their rate, plus a premium, is what we must demand of risk assets like equities. But in our current economy, government-issued bonds are anything but risk-free; the underlying currency of many currencies, such as the US dollar, have declined over a multi-year period while the yield on bonds has hovered near zero, thus giving US Treasury bonds a negative yield in real purchasing power over time. As such, CAPM fails to effectively value risk, as its starting point for a risk-free asset is false.
Historically, in such transitory times, gold has served as a store of wealth, eventually finding its way back into the international monetary system. Thus far, history seems to be repeating itself, as evidenced by gold’s run up over the past 10 years. Accordingly, I think equities must outperform gold to justify investment for the risk involved; gold is the new safe haven, and thus the basis for identifying the risk-free rate of return.
In addition, I add the following criteria for stocks to help spot specific opportunities:
- A market capitalization in excess of $1 billion.
- A P/E ratio under 11. In the 1930s, equities reached an average of P/E ratio of just above 5; accordingly, stocks that already have a low P/E ratio may not have much further to fall.
- A current ratio greater than 1, to ensure the company is solvent.
- Positive earnings and a dividend rate of at least 1%.
- Average annual income growth of at least 10% for each of the past five years, to find companies that can grow in the midst of an economic downturn.
- In the basic materials sector -- a commodities sector that I believe will perform well over the next few years, and one that has been doing well since 2000, which suggests a secular bull market is intact.
Below are six companies that most closely fit these criteria:
- Vale (NYSE:VALE) (Brazil)
- Braskem (NYSE:BAK) (Brazil)
- Rio Tinto (NYSE:RIO) (UK)
- Cliffs Natural Resources (CLF)
- Freeport-McMoRan (FCX)
- Rock Tenn (RKT)
The first three are American Depositary Receipts (ADRs), a way that American investors can invest in foreign companies. In parentheses, the company’s home country is listed; political risk and exchange rate risk must be factored in when investing in ADRs. I favor the Brazilian real relative to the US dollar, so I view this as posiive for VALE and BAK; I am not particularly bullish on the British pound, though I am not sure if the dollar can outperform it. I am a currency trader first and foremost, and both the pound and the dollar are currencies I prefer to hold short in the current monetary phase, as opportunities present themselves.
The majority of the companies listed are mining companies, which fits into the "gold as safe-haven" view I discussed previously. And as I noted in my article on mining stocks, I believe gold mining stocks are poised to do very well -- and continue to accumulate GDX and GDXJ as a result.