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  • Inflation: The Lowest Common Denominator

    By


    Nathan Kawaguchi

    IgnoreTheMarket.com

     

      

    At the Merriam-Webster OnLine dictionary, the first three definitions of value are:

     

    1:  a fair return or equivalent in goods, services, or money for something exchanged

    2:  the monetary worth of something

    3:  relative worth, utility, or importance

     

    From an investment point of view, these could be combined to broadly define value as, “A fair or equivalent return relative to that for which something can be exchanged.”  It is important to understand this fundamental concept of value in order to protect investment portfolios during this period of unusually wide ranges of probable outcomes.

     

    The most basic decision about money is whether to spend it or save it.  While people as a whole are irrational in the short-term, we tend to be more rational over longer periods of time.  It is fair to assume that in the long run, a rational person’s primary concern should be real present value, which is heavily impacted by the expected rate of inflation.  We know this is true by observing hyperinflationary economies. 

     

    Even in less-educated developing nations, consumers perform present value calculations, often unconsciously.  During hyperinflation, paychecks are cashed and spent immediately upon receipt because people know the money only buys a fraction of the goods later in the day.  Unfortunately, many people fail to make the same basic present value calculations when we move from consumer goods to investments.

     

    Because value does not exist in a vacuum, investors must identify a basis for comparison—a common denominator by which to measure relative value.  Most long-term investors compare expected returns of various investments to “risk-free” U.S. Treasury securities.  Some use rates on 2-year notes, while others use 5-year or 10-year rates.

     

    Treasuries and their “risk-free” rates, however, are not the most fundamental unit of monetary or investment value.  Cash is more fundamental than treasury securities because it is 100% liquid and has zero principal risk (treasuries have principal risk if liquidated prior to maturity).  As we observed in hyperinflation economies, cash derives its value from the rate of inflation.  This makes inflation the most fundamental common denominator.  So why is this distinction from treasury securities so important for investors? 

     

    This distinction from “risk-free” treasuries is important because the potential for rapid inflation exists due to the expansion of the Federal Reserve’s balance sheet.  Yes, inflation is currently being offset by the slowing velocity of money and deleveraging of the private sector.  But without increasing bank reserve requirements or other limiting measures, the probability of high inflation will remain elevated.

     

    This particularly makes sense for investors who believe in mean reversion.  It makes no less sense to believe that inflation is mean reverting than it does to believe that risk premiums (multiples) are. 

     

    Some argue that the current spread of earnings yields over “risk-free” treasury rates suggests a heavy allocation to stocks.  However, the historic spread of “risk-free” rates over inflation is historically low.  If higher, or even average, rates of inflation resurface, financial markets are likely to fall because inflation has a huge impact on the real present value of long-duration investments such as stocks and bonds.

     

    Currently, it appears that the conservative approach for long-term investors is to hold an appropriate mix of high-quality stocks, short- to intermediate-term bonds, and a significant amount of cash.  While it may be frustrating earning essentially zero on the cash portion, the opportunity cost of staying safe in cash is currently very low compared to treasuries. 

    If inflation remains under control, or if we experience slight deflation, the non-cash portion should perform as implied by market prices.  However, if inflation is reignited, it is likely to be accompanied by higher interest rates, which could disrupt markets and present opportunities for those investors patiently waiting with cash in hand.

     

    For more insight, visit IgnoreTheMarket.com.




    Disclosure: No Positions
    Aug 16 3:01 PM | Link | Comment!
  • Sustainable Competitive Advantages

    By

     

    Nathan Kawaguchi

    IgnoreTheMarket.com


     

    Most long-term business investors look for high-quality businesses.  But what exactly makes a business of high quality?  Unfortunately, many investors fail to ask themselves this very simple question.  High quality businesses are usually a result of a sustainable competitive advantage.  Let’s take a look at a few key competitive advantages.  Going through this exercise helps focus investors’ attention on the businesses that are most likely to offer extraordinary long-term opportunities.

     

    Low-Cost Provider

    People and organizations purchase goods and services for several reasons, primarily for need, convenience, improvement or pleasure.  Those purchased for improvement or for pleasure compete not on price, but on value added.  However, those purchased for need or convenience typically compete on price.  The lowest-cost producer has an immediate advantage over higher-cost competition.  This allows the low-cost provider to enjoy higher profit margins and allows it to drop prices and profitably take market share from competitors.

     

    Distribution Infrastructure

    All goods and services are sold and distributed through some identifiable infrastructure.  The companies that control these distribution networks can act as toll booths and collect fees whenever goods and services pass through.  While pricing in monopolistic infrastructures of basic living needs (water, sewage and electricity) is heavily regulated, pricing is moderately regulated when there are few alternatives (transportation and communications), and lightly regulated when there are many alternatives.  The best returns on capital are likely to be found in distribution networks established by demand rather than a lack of alternatives.

     

    Patents/Technology

    The profitability of inventions and innovation depend on the ability to prevent others from copying ideas.  This is most clearly evident in health care and technology industries, where many end products are completely dependent upon patent protection.  While businesses that depend on patents and technology can have relatively short-lived success, businesses that use patents and technology to add value can enjoy long cycles of success.

     

    Monopoly/Oligopoly

    Some businesses are monopolistic or oligopolistic.  Neither of these, in and of themselves, inherently leads to superior results.  It also depends on the nature of the products or service, or the level of regulation.  An example of this is in the aforementioned regulated utilities industry.  Monopolies and oligopolies can form due to special geographic characteristics that limit availability of goods or services.  Again, the best monopolies and oligopolies are those formed by demand because they are more natural, rather than forced, and are less likely to be regulated.

     

    Intellectual Capital

    Entire businesses can be built from a collection of data or from someone’s ability to think.  While information is becoming more readily available for collection in the information age, intellectual capital (people’s brains) is more difficult to copy.  Because data can be reproduced and ideas can be copied, information and intellectual capital is most valuable when it can be controlled or when it is time sensitive.  This is evident in the ability of highly skilled managers to collect information, evaluate it, and become the first mover with a new competitive strategy or business model.  In select businesses, such as investing, the same intellectual advantage can be applied over and over.

     

    Captive Audience

    A captive audience is extremely valuable because the cost of gaining someone’s attention is very high and the cost of gaining their business is even higher.  Not only is a captive audience expensive to gather, but it is extremely valuable once it is in place.  Because so much time, money and energy are spent trying to engage potential customers, businesses with captive audiences enjoy a certain type of leverage.  These businesses can instead focus their attention on business improvement and potentially cross-sell new products to their existing captive audiences.  A captive audience can be built through successful branding or through some unique physical location or relationship.

     

                Sustainable competitive advantages don’t necessarily exist in a vacuum.  Some businesses enjoy more than one of these key advantages.  For example, Coca-Cola (NYSE:KO) controls a majority of its distribution infrastructure, operates in a soft drink oligopoly, and has a captive audience.  Google (NASDAQ:GOOG) has access to key search technology, operates in a search oligopoly (nearly a demand monopoly), attracts and retains top intellectual capital with its unique corporate culture, and has a captive audience as it offers one of the most frequently used services in the world.

     

                Sustainable competitive advantages can become even more deeply entrenched when combined with other favorable characteristics such as high switching costs, convenience, key relationships, scale, and habit formation through frequently recurring consumption and purchase decisions.

     

                This is just a brief overview, but it is often helpful to revisit the most fundamental elements of investing, especially in the face of uncertain times.

     

    For additional insight, visit IgnoreTheMarket.com.




    Disclosure: No positions
    Jul 08 1:25 PM | Link | Comment!
  • Opportunity Knocks (Volatility is Back--Yes!)

    By

    Nathan Kawaguchi

    IgnoreTheMarket.com

     

     

                Investors were spooked this week by Greece, the Euro and a possible trading glitch.  Whatever the reasons, I am just happy to welcome back volatility.  Value investors live for volatility because it presents the rare buying opportunities on the downside and selling opportunities on the upside.  Because prices generally move upward in the long run, the downside volatility is much more difficult to come by, so investors cannot afford to waste the rare buying opportunities when they present themselves.

     

    Although the past year has produced spectacular returns, the last six months or so have been relatively uneventful for conservative value investors.  The steady rise over the past several months has taken stocks into fair value territory and beyond.  Without any meaningful corrections along the way, many conservative value investors have been forced to sit and wait for the next opportunity.

     

                As usual, patience is paying off.  While the recent correction has only erased year-to-date gains in the overall market, the price movements in many individual stocks have been much more severe.  Because we are coming down from moderately overpriced levels, there is not yet an abundance of bargains available.  What investors should be doing right now is making a shopping list and looking for opportunities to put cash to work incrementally, should prices continue their downward trend.  This is assuming, of course, that investors still have cash to put to work.  At IgnoreTheMarket.com, we have been recommending a large cash position since October 2009.

     

                Because the past year’s rally has mostly rewarded risk (the so-called “dash to trash”), many larger, higher-quality stocks are selling at relatively more attractive valuations.  This should be the first area in which to look for investment candidates to add to a shopping list.  This is especially true if people are correctly worried about another significant global selloff.  The higher quality names should hold up better relative to the “trash” in the event of another crisis.  To quote Howard Marks, “We don’t know where we’re going, but we sure as heck ought to know where we are.”  Happy bargain hunting.




    Disclosure: No Positions
    May 07 7:41 PM | Link | Comment!
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