Potential Investment Thoughts - May 2016

by: Income Surfer

This post is about potential investments, but first I wanted to address the topic of passive index investments. We have taken some amusing heat, and received some hilarious comments/emails, surrounding our intention to transition a portion of our portfolio to include a larger percentage of passive index equity investments. (Click this link if you want to read about our proposed portfolio allocation.) First, we were teased by readers who thought we were abandoning our dividend growth investing roots. Dividend growth investing is (and always has been) PART of our portfolio, but it is not our sole methodology. Currently, many companies that fall into this group are so astronomically expensive that I would not buy them with your money. (You read that right, not only wouldn't we buy them with our capital…. but we wouldn't buy them with yours.) So should we blindly purchase expensive shares, which in my opinion offer poor future returns, just because we previously bought shares in those companies at grossly lower prices? I think not. We will search for other opportunities that offer better value, and wait for those opportunities to materialize.

Then, we got another round of comments/emails when we published an article talking about how we wanted to add a couple of Vanguard index ETFs to the core of our portfolio. What can I say, there are a few advantages to investing through passive index funds… and we would like to capitalize on those. As part of this transition, we looked at our investments and determined which ones had the potential to be our "long term holdings"…. and then began selling off the ones that didn't make the cut. Which takes us to today, except that we haven't invested very much of the free capital that resulted. So now we are starting to get comments/emails about why we haven't redeployed all of that capital into the Vanguard index ETFs we specified. The reason is simple, it's all about price and value.

We see the risk/reward balance of most global equity markets being slanted heavily against us. To put it another way, I feel we would be risking a lot in order to potentially gain a little. There are plenty of indicators that suggest the bull market in equities is already over, and we are not going to risk a large amount of our hard-earned capital in order to potentially gain at best a small return. (I am not going to waste your time recounting those indicators today. We each believe what we choose to believe.) Playing to our advantages listed above, that is our prerogative. Unfortunately, many passive index investors are new to passive index investing… and don't realize that passive index investments can and do decline in value along with their benchmark index. Plus, there are issues with what exactly you are buying… when you buy a capitalization weighted index fund. I predict this will be a hard lesson for them. (I am also humble enough to recognize that I could be wrong.) It probably won't be a big deal if they don't panic and sell… but heaven help them if they do. In summary, we have freed up the majority of the capital we intend to… as a result of culling the individual stock holdings that didn't meet our "long-term holding" criteria. We have not redeployed much of that capital into passive index investments yet, because of the reasons discussed above.

We always strive to recognize the things we can control and the things we can't. This concept is a large part of while this blog has the name it does. In surfing, you have to wait patiently for the ocean to offer up quality waves… then it's up to you to do something with them. We can't control the waves we are offered, only what we do with them. Sounds a little bit like investing, doesn't it? While valuation/price keeps us from buying passive investment at the moment, we see some pockets of opportunity on the horizon. Below are my personal thoughts:

Courtesy of Wikipedia

Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) - It feels odd to me, to be considering this well-known behemoth at the moment. That being said, Berkshire's "old world" businesses have reduced company profits recently and along with them… suffered from reduced investor sentiment. Dampening the outlook for the company, Buffett spent quite a while talking about the headwinds facing both the railroad and insurance industries at the Recent Annual Shareholder Meeting. That being said, Berkshire probably has the management team that is most likely to profit from a severe recession or stock market meltdown. Buffett/Munger have exploited market sell-offs several times in the past, and they have plenty of cash to put to work today. I am not a buyer today, with shares in the low $140 range. At this price, the company offers a trailing price to earnings ratio of 14.3, which is that is well below the broad S&P 500. I expect profits to decline again for 2016, and Buffett all but told us as much at the annual shareholder meeting. We will begin accumulating shares below $125, as I believe this level will provide a satisfactory return over the next 20 years…even when reduced profits in the near term are taken into account. Please note that I do not expect Berkshire to put up annualized returns as high as it has over the past 30 years, but I see this group of companies as a compounding machine whose structure allows management to reinvest earnings in an efficient way for decades to come. Slow, steady, and with fantastic free cash flow Also note, at the start of the year I said as much in Roadmap2Retire's article on 2016 Investment Picks.

Courtesy of NationalWesternLife.com

National Western Life Group (NASDAQ:NWLI) - Regular readers know that we have made several successful deep value swing trades in this company over the past two years. To recap, it is a small insurance company with high insider ownership, no debt, and a history of solid profitability. With a price to earnings ratio below 8 and Shiller price to earnings ratio below 9, we will continue to accumulate shares in this company. We do, however, recognize that given the company's small market capitalization, share prices may swing wildly over the coming years. We'll be patient, as always.

Unfortunately, none of our long-term holdings are particularly close to levels where I would add to those positions. Wells Fargo (NYSE:WFC) is probably the closest, but has quite a ways to fall before we start buying again. On the flip side, I see the prices that shares of most utility and consumer staples companies are currently trading… as absolute madness. I continue to believe prices have been bid up over the past few years as a result of bond investors buying these "bond proxies" for steady income. Companies like Procter & Gamble (NYSE:PG) and Clorox (NYSE:CLX) do pay a steady dividend… but between high debt levels… high price to earnings ratios… and pitiful earnings/revenues…these shares look particularly dangerous to me.

In the coming months, I believe we will get a huge opportunity to invest in emerging markets. We added a few thousand dollars to our holdings in Vanguard's Emerging Markets Index ETF (NYSEARCA:VWO) earlier this year at $28.44. I continue to expect the emerging market equities to tumble significantly in the coming months…with the catalyst being currency exchange issues, global slowdown, bond market issues, etc. These are still assets we want to accumulate, and I expect their returns to be significant over the next 15 or 20 years.

Courtesy of Wikipedia

I am going to go out on another limb here, and talk for a second about real estate investment trusts. We hold a few shares of Vanguard's REIT Index (NYSEARCA:VNQ). We have no intention of adding to these shares in the near term. I am starting to see ominous headwinds developing for this asset class, however. While the last real estate crisis was spurred by single family homes, I believe the next one will be the result of two other subgroups. Commercial retail properties and apartment properties. In our part of west central Florida, there has been an apartment building boom for the last 6 years. The narrative went that all those apartments would be filled by all the people who were foreclosed on. Their credit was too poor or they were too scared to buy a home again…so they would rent. Fast forward a few years, and this narrative has overshot as these things often do. Cheap lending and reduced land prices allowed these projects to get off the ground…and they are still being built…but vacancy rates are falling as the finished apartment units are coming online. I suspect rents in my area will begin to contract, which will be the last indicator that some of these projects will default on their debt.

I believe the other issue will come in the form of retail commercial properties. It's been well documented, since at least the mid-1990s, that the United States has more "bricks and mortar" retail properties than any other nation in the world. Over the last few years, we have also seen two huge retail trends. 1) Consumers are spending less money than they used to, and 2) When consumers are shopping… a higher percentage of those sales are taking place online. Americans love their retail, I know it… believe me. I worked as a commercial developer in Florida for a couple of years, and represented developers in Florida for another 8 years. Low interest rates and banks being desperate to lend out their capital has allowed a massive building boom. I'm not saying all American retail is doomed, but there are a lot of lower quality locations out there… which have barely been hanging on. I expect them, maybe 25% or 30% of the total aggregate, to give up the ghost over the next 5 years. If you need a data point to indicate that bricks and mortar retailers are suffering, look no further than their terrible earnings over the last couple of quarters.

Please take my thoughts with a grain of salt. All real estate is local, but I noticed similar trends all across the country on our recent (nearly) 10-Week Roadtrip. Some areas like Denver, Colorado, have such an influx of residents that I'm sure they can absorb the new capacity. Many other areas (like our part of Florida or Central Indiana) are in for some pain.

Where are you finding value in equity and fixed income markets, currently? What trends do you see developing?

Disclosure: We are long WFC, NWLI, VWO. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. Please do your own research. I am not a financial professional. The information above is provided by Yahoo Finance and Morningstar.com.