Like any of you who agree with me that the economy is going to be significantly challenged for quite some time, I struggle with how to invest (if at all). If you don't agree with me, then this article is not likely to be useful to you. If you too believe that we are likely to confront headwinds like we have never experienced, you might appreciate some of these ideas on coping with the environment.
I used the rally last week to raise a lot of cash as well as to reduce exposure in my Conservative Growth/Balanced model portfolio to 56% stocks compared to a neutral 60%. While the market remains oversold and could appreciate more, I am trying to position the portfolio to better reflect the fundamentals subsequent to the Wile E. Coyote falling off the cliff back in late September. If you don't remember that Looney Tunes battle, here is a great reminder. I am disappointed that it took me way too long to realize where we were after having been so bearish in the summer of 2007, but the rest of this article reflects the views I shared several weeks ago. I believe that the market has started to behave more rationally recently, with better two-way flow and better discrimination among the individual stocks, so this is actually a good time to restructure portfolios and reduce exposure to stocks or other investments that no longer make sense.
The first order of business is to get the overall exposure to risky assets in line. While "zero" may very well be the right number, it can be impossible (guidelines if you are a fiduciary) or too risky (if you are wrong). In an economy that is starved for credit, realize that any asset, even "risk-free" Treasuries are vulnerable to sale. While stocks, corporate and asset-backed bonds, many commodities and tangibles such as art have certainly demonstrated this vulnerability, commercial real estate too should soon show dramatic weakness. Some stocks will certainly go up as the companies might be in a position to actually benefit or at least be unaffected by the recession or may benefit from rotation by investors who have to hold some stocks (the least worst), the vast majority will be cheap and get cheaper as long as leverage is contracting throughout the economy. So, the answer to "how much" is "as little as possible".
If one accepts that the path of stocks is likely lower but has to hold some stocks, I suggest the following:
- Invest in companies with strong balance sheets but low valuations
- Try to identify potential beneficiaries
- Be willing to trade
I have been emphasizing high quality stocks since I began writing on Seeking Alpha in early 2007. In an environment where future earnings are so suspect, investors have increasingly been turning to different types of valuation. While many use "Price to Book", I prefer to strip out intangibles and the goodwill accumulated via acquisitions and focus on price to "tangible book value", which is more conservative. Since asset prices are in general decline, though, one has to pay special attention to the composition of the assets on the balance sheet. Is the inventory correctly valued? Are the receivables actually collectable? Is the carrying price of factories, equipment and property realistic in a liquidation? Avoid companies with a lot of debt (a lot might be ANY debt), especially short-term debt in excess of cash. The company could be forced to sell stock or to shed assets below carrying cost to cover debt maturities. Finally, be especially wary of companies that have unsustainably high dividends.
I have shared a few themes of possible beneficiaries of the shrinking economy. Make no mistake: In an economy that is 70% related to consumer spending, GDP will most likely be contracting like we haven't seen. Retail sales have fallen at an annualized rate of 25% over the past three months. Even stripping out autos, which certainly removes one of the major drags and also allows my data to go back further, the annualized rate of decline has exceeded 18%:
Not only was is this decline unprecedented in my life-time (44 years), the rapid decline, literally off-the-chart in the middle panel, well eclipses the hit we took after 9/11. With the consumer accounting for so much of the economy, it is likely, in my opinion, that we will suffer perhaps the worst annual decline in Real GDP in my lifetime as well (almost -3% in the early 80s). Nominal GDP could actually come in negative for 2009: Consumer should decline greatly, business capital spending will plunge, and net exports should be a drag. The government sector, which accounts for about 20% of the economy, can't grow fast enough to offset these hits. Most companies will see falling revenues and even sharper drops in earnings as profit margins are squeezed.
I have written about several sectors that are of interest to me: pawn shops (like EZCORP (EZPW) or other providers of credit outside of the traditional credit card or retail lending industry (like America's Car-Mart (CRMT), auto repair stores, and food processors (like Hormel (HRL)). I think that another area might be security-related firms, whether its burglar alarms, guns or Tasers. Finally, unfortunately, we might have geopolitical unrest, which would suggest investing in companies that help provide national defense. In a bad neighborhood, some of these types of companies could be the best houses on the block. The three stocks above are among my largest holdings. Another large holding is a PBM, Catalyst Health Solutions, formerly HealthExtras (CHSI). I don't view this as a beneficiary, but rather one that might not be impacted too badly.
Finally, in a wild and crazy market, we should let volatility be our friend. If there is sudden demand for one of my stocks that I think is an overreaction to short-term news, I just sell it, or at least a substantial portion of it. Likewise, when a stock that meets my criteria for safety in terms of balance sheet is signficantly oversold for what I view as a temporary issue, I buy it. These wild gyrations in the market have allowed me to add to returns. It is important to be willing in a bear market to sell so that we have cash to buy later. Never has "trading" in the context of a long-term portfolio been as potentially lucrative as it is now. With hedge funds losing assets rapidly and scaling back bets as well, one of the market's most notorious liquidity providers has become a fraction of its former self. I could offer many examples, but one that I would like to share is Astec Industries (ASTE). I added to my position at the time when it traded below 18 (in utter disbelief). I scaled out on the way up and closed out my position at 30.86 amidst the crowd chasing "infrastructure" plays. While I lament not getting that last point or two, I was able to redeploy the proceeds into another extremely oversold issue at the time (not too hard to find these days).
So, cutting exposure, really focusing on absolute safety by emphasizing a strong balance sheet, a willingness to trade more opportunistically and pursuing a few themes that don't seem to be on everyone's radar yet are some of the steps I am taking to cope with this environment. I welcome any other ideas!
Disclosure: Long EZPW, CRMT, CHSI and HRL
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