2012 Investment Choices To Cope With The 'Great Contraction'

by: March Ahead

In this article, I present my investment choices for 2012. Economist Ken Rogoff has called the post 2008 economic crisis as the "Second Great Contraction" and this article discusses the current economic themes and investment ideas.

The major reasons behind my investment choices are as follows:
1. This time is not different. Asset prices tend to follow mean-reversion.
2. Seek to buy fundamentally strong, but undervalued assets and focus on margin of safety. Avoid over-paying for currently prevalent fads.
3. Do not lose money; and safety is more important that yield.
4. Don't make predictions for short term but focus on economic factors that will impact long term returns

Current economic themes and their long term implications:

1. Private debt as percentage of GDP is still high

Private debt is still at a very high percentage of GDP. As individuals try to reduce their debt loads, consumer spending is likely to remain at depressed levels for the next decade or so. The underlying theme here is that private debt will revert to long term mean.

Private debt as % of GDP. Taken from Steve Keen
Chart 1. Debt ratio = Private debt as % of GDP. Taken from Steve Keen's Debt Deflation blog.

Chart 1 shows that it will take until 2025 to reach close to public debt ratio of 75% (long term average of public debt percentage) if the debt reduction follows the current trend of 7.8% reduction per annum.

2. Demographic effect of baby boomers retirement on P/E ratio

A recent article from the Federal Reserve of San Francisco (full article here) predicts that the P/E ratio of stocks will reduce to ~9 by 2020. Chart 2 shows strong co-relation between M/O ratio (the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69) and P/E ratio.
Chart 2: Red - S&P 500 P/E ratio, blue - M/O ratio. Dotted line indicate model. Taken from Federal Reserve of SF economic letter.

Chart 2 also implies that with conservative estimates for earning growth, the stock market is likely to decline gradually till 2020 (the Federal Reserve article says the decline will be 13%). Where have we seen similar situation in the past? A similar theme was seen in Japan after their housing bubble and baby boomer retirement. The Nikkei has shown strong co-relation of stock prices with the "35-54 year dependency ratio".

35-54 year dependency ratio = (Number of people in 35-54 age range)/(Total population).

Chart 3: Strong co-relation is seen between Nikkei index and 35-54 year Dependency ratio in Japan

These predictions of S&P 500 P/E going lower might not come true. But in case they do, one should be prepared. A good way to protect one's portfolio in such a case is to buy low P/E stocks with margin-of-safety.

3. Europe and China issues

The oft discussed sovereign debt issue faced by Europe could throw nasty surprises this year. Chinese stocks have been dogged by fraud and Chinese real estate shows signs of a bust (whether hard or soft). These topics have been widely discussed in Seeking Alpha articles. As a result, I am trying to avoid stocks with huge exposure to China or Europe.

4. Gold and silver have shown rapid rise in recent times

A recent Seeking Alpha article by Carlos Alexandre shows that gold and silver prices have increased rapidly in the recent years (article here). Though gold and silver can be considered as insurance and an asset with low co-relation to stocks and cash, the current prices of gold suggest that its over-priced relative to it long-term mean price. I am going to stay away from gold until it reverts to its long-term mean price.

Investment choices:

Based on the above themes, I've decided on the following choices for 2012:

1. Buy farm related stocks

Cresud (NASDAQ:CRESY) is an Argentina based farm land company which gives you equity equivalent to 1 acre of land for every $637 invested in the company. This price for highly fertile land from Argentina is significantly lower than prices for farmland in North America and in parts of Asia. This perfectly fits the criteria of buying under-valued stocks.

Potash Corporation of Saskatchewan (POT) is the world's largest producer of potash. The stock has declined 24% since the beginning of 2011 due to over-supply of potash and decline in demand. This represents a good entry point with current P/E of 12.6. The long term outlook for POT is great due to expected high demand for potash to support ever-increasing population.

2. Focus on dividend paying, safe businesses

There has been higher demand for dividend paying stocks recently. Investors are focusing once again on yields instead of only focusing on capital gains. Dividends on some stocks are now higher than corresponding yields on corporate bonds issued by the same company (list of such stocks is given in Deutsche Bank's Long Term Asset return study). This marks return to old world investing where investors demanded higher yield for stocks (riskier) as compared to bonds.

Utilities are safe stocks with stable revenue streams, and greatly useful in uncertain economic situations such as the current one. They provide great dividends, have low beta, and are usually protected through regulatory practices ("moat"). My favorites are National Grid Plc. (NYSE:NGG) and Southern Energy (NYSE:SO).

Railroads have seen an increase in traffic due to increased adoption of inter-modal transportation (hybrid usage of railroad and trucking to optimally transport goods). Railroads are now around 4 times more fuel efficient than trucks. As oil prices increase, the significant benefits of fuel saving using railroads will lead to increase in tonnage carried via railroads. Among railroad stocks, I like Norfolk Southern (NYSE:NSC) and CSX Corporation (NYSE:CSX).

3. Sell cash secured puts to increase yield and to buy stocks at discount

Selling cash secured puts on stable stocks (such as utilities and railroads) provides a way to increase yields on the stocks that one already owns. Around 85% of the options are never exercised. In case the price falls and one is assigned the stock, one gets discounted price on great stocks and add more to one's current stock holdings. Seeking Alpha articles focusing on this topic in depth are here and here.

4. Instead of buying oil companies, buy drilling equipment makers:

When the price of commodities increase, the companies which engage in oil extraction such as Exxon Mobil (NYSE:XOM) have to tread carefully. These companies have to invest heavily in equipment for extracting oil. When prices of commodities rise, they have to be able to transfer those costs to end consumers in time. Also, the workers start demanding higher wages when commodity prices go up. Thus, profits from these companies do not display a linear relationship with underlying commodity (in this case, oil) prices. Further, according to Jim Chanos (presentation from Value Investing Congress 2011), these companies are slowly leaking value because of increased research & development costs for each new discovery. As rich reserves start dwindling, the integrated oil companies are exploring newer, less dense reserves in order to extract oil and this causes exploration, research & development and production costs to rise.

Instead of buying oil companies, buy equipment makers such as National Oilwell Varco (NYSE:NOV). NOV provides drilling equipment to 9 out of 10 rigs currently in production (from Motley Fool's Stock Adviser). As it becomes tougher to extract commodities whose reserves are dwindling, equipment in larger quantity and having better technology will be needed and this means excellent prospects for NOV.

5. Build up cash reserves to buy more on dips

If you don't see great opportunities right now, just build up cash reserves which will you to buy more stock on dips.

6. Avoid Mortgage REITs with huge leverage and too-high dividends:

Would you buy Mortgage REITs if their dividends were very low? The prime reason that REITs are a fad in the last 2-3 years is because of low short term interest rates and high dividends paid by REITs. The high dividends are possible due to high leverage, which translates to risk when conditions turn unfavorable to REITs. The long term mortgage interest rates are reducing due to depressed housing demand. This will tend to decrease the profits for REITs. When their profits fall, the dividend ratio will fall and cause investors to flee leading to decreased stock price. In short, buying mortgage REITs amounts to greed for high yield in the current times, while ignoring long-term threat to capital.

Disclosure: I am long NSC, NGG, NOV, CSX, SO, POT, CRESY.