The following was published by RealMoney on 4/26/2006. As with all of these “classic” articles, I republish them because they aren’t available at RealMoney any more. They changed their system for links, and so articles and comments that I put a lot of work into have disappeared.
If you believe in the trend but prices are high, take a half position.
Despite U.S. automakers’ woes, cars will be built by someone; this makes stronger parts suppliers a good play.
Global economic development means more demand for chicken.
One of the most important things to understand with investment ideas is what time period they are for. Sometimes a given asset can take different directions over the short, intermediate and long terms.
Imagine for a moment that you buy the thesis that a large portion of the world is joining the capitalist economy, and that this will lead many more people and businesses in developing countries to demand more goods consistent with what we view as a middle-class lifestyle. That’s a secular trend that will play out over many years. It can be a guiding theme that can help organize investment ideas over the long term.
Now, say that your interpretation of that secular trend implies higher worldwide demand for foodstuffs, metals, timber and energy. However, when you look at the valuations of some of the companies affected by the trend, they appear to be too high, and profit margins are above historical norms. (Valuations are in fact reasonable for many companies in these sectors, but play along with me for a moment.)
You are faced with a problem, then. You think the secular trend is valid, but that much of the story is presently anticipated by current valuations. What to do? One technique that I have used in situations like this is to buy half of what I would if valuations were reasonable (which occasionally aggravates my boss, who is an all-or-nothing kind of guy).
If the stocks go down, I would come up to a full position. If the market gets crazier and valuations rise, I would punt out the smaller position for a gain. If the market muddles somewhat trendlessly, I would buy and sell using my rebalancing discipline, which will clip a couple of extra percentage points over time.
There are alternatives, though. You could buy a full position, but then you are committing to the stock for the long run on the idea that the secular trend will dominate over valuations. You’d better be right, because with higher valuations than normal, being wrong has a greater cost.
You also could do nothing. After all, valuations are extended, and you won’t just pay anything for a stock. This strategy presumes an interruption in the general trend will be coming. That may or may not happen; high valuations often get higher for stocks in a winning thesis. Paying up for a good idea is often a good strategy, but the tradeoff between valuation and the secular trend is a difficult balancing act.
Part of working that tradeoff comes with experience, but I would argue that it also requires humility — the market always finds a new way to make a fool out of you. Always consider what could go wrong. Conservatism means that you will always stay in the game, and staying in the game for a long time is the secret to compounding returns.
The Internet Bubble
Let me give you a few real-world examples. Think of the Internet bubble. The long-term prognosis that the Internet would be big was correct (in hindsight), but valuations were screaming “Don’t play here,” and many concepts were quite marginal from a cash-flow standpoint. That said, the technicals were screaming, “Momentum, baby! Time to play!”
My solution was to sit it out. I figured that, eventually, the cheap financing would run out and the market trend would shift. The problem was, it lasted two years longer than I anticipated.
Maybe I left something on the table. I could have played with smaller position sizes, or played with a mental “stop order” in the back of my mind. That said, it didn’t fit my personality, and I didn’t feel that I could evaluate who the survivors would be, so my optimal decision was to sit it out. (I didn’t short it because the momentum was too great. Never argue with a liquidity wave.)
Industries in Secular Decline
What if you are looking at an industry in secular decline, such as the photo film business (think of how Eastman Kodak Company (PINK:EKDKQ) has fumbled, or, worse, Polaroid), fixed-wire phone service companies, or the newspapers? All of these are being displaced by new technologies.
Verizon Communications Inc. (NYSE:VZ) looks cheap and has a nice dividend. Is it a candidate to buy?
This is an example of Warren Buffett’s concept of “cigar butt” investing: Someone may have tossed it on the ground, but you can still get a few good puffs out of it. The company has limited growth potential unless a radical new strategy gets introduced, and that could be costly, or even fail. I had better get this company extremely cheap to compensate for potentially falling earnings at some point in the future. Even a wasting trust has a proper price, so if I can get it at a level that reflects a 15% annualized return, that could be a great investment. One nice thing about declining industries is that there usually isn’t a lot of direct competition.
Here’s one more example: auto parts. I own Johnson Controls, Inc. (NYSE:JCI) and Magna International Inc. (NYSE:MGA) (TSE:MG) , two companies with strong balance sheets that are picking up market share against weaker competitors. Automobiles are going to be built, even if General Motors Company (NYSE:GM) and Ford Motor Company (NYSE:F) aren’t going to be building as many of them.
This is one part of the auto sector where you can have moderate growth, and the stronger suppliers can do far better than the average. I still want to buy them cheap, but I can afford to pay a little more for quality in markets where quality is scarce. In this case, lower-quality companies could be cheaper, but they aren’t the ones to buy when an industry is under stress.
As the developing world grows, so will demand for animal protein. To me, that means chicken.
Valuations are favorable here, because many investors are scared about avian flu. Whole flocks of birds might have to be culled if even a few get sick. That said, large North American poultry producers isolate their birds from wild birds, and even from humans who have the flu.
The risk is overstated, and once the pandemic is over, valuations will rise. (Some people are mistakenly avoiding chicken, even though there is no chance of getting avian flu if the chicken is properly cooked.) I own Gold Kist (GKIS:Nasdaq) and Industrias Bachoco, S.A.B. de C.V. (ADR) (NYSE:IBA), but am considering whether I shouldn’t increase my exposure and add Pilgrim’s Pride Corporation (NASDAQ:PPC), or Sanderson Farms, Inc. (NASDAQ:SAFM). Tyson Foods, Inc. (NYSE:TSN) is too diversified, and I’m not crazy about the management.
Full disclosure in 2013: I am still long Industrias Bachoco, S.A.B. de C.V. (ADR) (NYSE:IBA) — what a great unknown company.
By David Merkel, CFA of Aleph Blog