Saturday, March 31, 2012

Rotating Market Sector Themes

The world changes every day, every hour, minute and second. Yet the same patterns re-emerge in terms of human behavior; this is in particular true in the financial markets. These markets seem to encompass our goodness but also all our weaknesses and sometimes our outright nastiness. We, investors, often behave like a mob with mob psychology following blindly the hysterical outcries of the mob leaders – pundits - without thinking whether what they say is realistic. Last year’s nasty correction with the U.S. debt ceiling and European debt crisis was a prime example.

Yes, the market pundits speak often from a pure business/capitalist perspective combined with the impatience of a rebellious teenager who thinks that he has figured out the world. These closet capitalists with temper tantrums and with nothing more in sight than short term profits (something in which they are aligned with many investors), forget that the world is about more than strictly business interests and smooching with the corporate leadership. There is a whole different world out there with religious views ranging from ‘New Age’ to Christian and Muslim fundamentalism; from strong families focussed on raising children and having nice Sunday BBQs to people in Africa suffering from leprosy.  These other worldly aspects are governed, with all its shortfalls, by the public sector – our politicians. The objectives of our politicians – including their re-election and crowd control methods – are often quite different than strictly economics. Thus it took a lot longer and it is was a lot more complex than thinking in terms of pure investments  and economics to arrive at a solution for say the European Debt Crisis. As successful, diversified investors we should be able to make the distinctions between these different worlds and believe in the long term survival and prosperity of the human race. We need the optimistic attitudes of Gene Roddenberry’s Star Trek. After all, why invest if you truly believe in those ‘end-of-the-world scenarios’. If these scenarios ever would come out nobody would make profits.  That is why Louis Rukeyser was so successful as an economic commentator and with his TV pioneering program “Wall Street Week”; that is why Warren Buffett is so admired and successful with his perpetual believe in the creative powers of the U.S. economy. That is why John Templeton combined his religious values so successfully with his value investing acumen.  They all believed in a better more prosperous future and they looked beyond pure investment metrics.

They also know that the world and the financial markets continuously change and that the markets are emotional beasts that overreact to that change creating opportunities for profit. They also know that you have to be diversified because things change; that today the bond market and tomorrow the stock market will outperform. They know that today Apple may lead the charge, yesterday Blackberry did lead and that tomorrow it is once again Microsoft’s turn J.  Also, market sector performance is variable and depends on the socio-economic climate and on the business cycle. Oil (and Gas) industry is a prime example, but so is the Insurance sector.

We are often told that Gold is the big inflation protector; we’re switching from interest to dividend paying stocks just when we’re nearing the bottom of the interest rate and inflation cycle. Many of us seem to be experts at mis-timing the trends and markets – trying to benefit from these trends just when they reach their end. Our timing is often so disastrous because we don’t jump until all ‘traffic lights are on green’ – an analogy I made in this blog about a year or so ago. But once all lights are on green they can go only one way – some or all will turn red pretty soon. We have to recognize investment themes far in advance and invest in them. Then we’ll need to have the patience of Job to see them play out. Finally we have to take profits when our investments in these trends become overvalued.

Nobody likes natural gas companies right now. Everyone knows how bad it is. But people like Peter Tertzakian and T.Boon Pickens recognize the real potential of this commodity.  People like Jeff Rubin recognize trends far before their time although sometimes they get carried away with their predictions or there are other factors that were not taken into account. Recognizing trends can be very profitable but not every trend develops the way it was extrapolated. Peter Tertzakian and others recognize that natural gas is now increasingly used by the utilities industry; that North American transportation will become fueled increasingly by natural gas (will that inhibit the development of hybrids or electric cars? Who knows!).  Tertzakian recognized that these new trends are hidden under the effects of an anomalously warm winter. Natural gas supply is waning in spite of all the NGL and shale gas hype. Now when times are blackest, a reversal is approaching fast. Higher natural gas prices will be upon us when most investors least expect because of their ‘herd and pundit’ mentality. You may be early; you may catch a few falling knives if you’d move into natural gas companies full blast. Instead you could start to nibble and buy a few diversified oil and gas companies with solid balance sheets and good management - companies that now are out of favor. Do it as a small part of your portfolio and do not overweight your portfolio. With a toe-hold in the water, you can add to these holdings once things become clearer.

Here is another trend that is developing. Stocks are productive assets contrary to gold as pointed out by Warren Buffett. The companies that underlie the stocks will often have increased pricing power when inflation increases fuelled by ever increasing government debt and by a better performing economy. The nominal earnings of those companies (not-corrected for inflation) and thus their share prices will probably increase. Furthermore because these companies are leveraged their appreciation is likely to outpace inflation. Not only will stock markets benefit from higher (but still reasonable) inflation, interest rates will rise as well. What industry will benefit from those conditions? The financial industry – banks but even more so will the insurance industry benefit.

Insurance companies receive client’s premiums far ahead of the claims that they will pay out. They will also get profits from underwriting income. All this money is used to invest and to enlarge their profitability – basically all that cash inflow is an interest free loan from their clients! Banks get money from their depositing clients but they have to pay interest on these deposits – insurance companies do not.  This is one of the reasons that Berkshire Hathaway which owns major U.S. insurance companies such as Geico is so successful. With poor stock markets and low interest rates, combined with too risky products Canadian insurance companies suffered greatly between 2008 and today. But that is quickly changing and today I foresee that Manulife, Sunlife, GreatWest Life (owned by Power Financial and Power Corp) are once again attractive and they may prove to become your best investments in an more inflationary future.

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