Value Investing: Cheapness versus Economic Cyclicality

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Value Investing: Cheapness versus Economic Cyclicality
Photo Credit: Paul Saad

Photo Credit: Paul Saad || What’s more cyclical than a mine in South Africa?

This is the first of a series of related posts.  I took a one month break from blogging because of business challenges.  As this series progresses, I will divulge a little more about that.

Mohnish Pabrai On Value Investing, Missed Opportunities and Autobiographies

Mohnish PabraiIn August, Mohnish Pabrai took part in Brown University's Value Investing Speaker Series, answering a series of questions from students. Q3 2021 hedge fund letters, conferences and more One of the topics he covered was the issue of finding cheap equities, a process the value investor has plenty of experience with. Cheap Stocks In the Read More

When I look at stocks at present, I don’t find a lot that is cheap outside of the stocks of companies that will do well if the global economy starts growing more quickly in nominal terms.  As it is, those companies have been taken through the shredder, and trade near their 52-week lows, if not their decade lows.

Unless an industry can be done away with in entire, some of the stocks an economically sensitive industry will survive and even soar on the other side of the economic cycle.  At least, that was my experience in 2003, but you have to own the companies with balance sheets that are strong enough to survive the through of the cycle.  (In some cases, you might need to own the debt, and not the common equity.)

The hard question is when the cycle will turn.  My guess is that government policy will have little to do with the turn, because the various developed countries are doing nothing to clear away the abundance of debt, which lowers the marginal productivity of capital.  Monetary policy seems to be pursuing a closed loop where little incremental lending gets to lower quality borrowers, and a lot goes to governments.

But economies are greater than the governments that try to milk them.  There is a growing middle class around the world, and along with that, a growing need for food, energy, and basic consumer goods.  That is the long run, absent war, plague, resurgent socialism, etc.

To give an example of how markets can decouple from government policy, consider the corporate bond market, and lending options for consumers.  The Fed can keep the Fed funds rate low, but aside from the strongest borrowers, the yields that lesser borrowers borrow at are high, and reflect the intrinsic risk of loss, not the temporary provision of cheap capital to banks and other strong borrowers.

It’s more difficult to sort through when accumulated organic demand will eventually well up and drive industries that are more economically sensitive.  Over-indebted governments can not and will not be the driver here.  (Maybe monetary policy like the 1970s could do it… what a thought.)

So, what to do when the economic outlook for a wide number of industries that look seemingly cheap are poor?  My answer is buy one of the strongest names in each industry, and then focus the rest of the portfolio on industries with better current prospects that are relatively cheap.

Anyway, this is the first of a few articles on this topic.  My next one should be on industry valuation and price momentum.  Fasten your seatbelts and don your peril-sensitive sunglasses.  It will be an ugly trip.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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