I have argued that investors should “create their own conglomerate” of high quality companies, mostly growth companies that pay dividends, and own them for long periods of time. I know this sounds like just another dumb investment platitude. Now we have a practical example of what it means, in terms of real world decision making.
OMG, the Dollar Is Soaring
Wall Street is in a tizzy about the strong dollar, which will hurt the reported earnings of multinationals and depress commodity prices as denominated in dollars, which is bearish for energy stocks, gold stocks, other commodity stocks, and the industrial companies that supply them with capital goods. Analysts, strategists, and economists are busy revising their forecasts to take account of the strong dollar.
What should you do with your portfolio in response to the strong greenback? You should do very little, for a few reasons. For one thing, currencies are not forecastable, so you are wasting your time thinking much about them. (I, like many others, have incorrectly expected the Euro to weaken for the last three years.) For another thing, whatever effect a strong dollar has on companies’ earnings is already priced in; it’s too late. But most importantly, currency is not that important to a multinational firm with operations around the globe. Yes, eventually (like two years from now) the strong dollar may reduce U.S. exports, but it will increase European and Japanese exports, so the underlying impact of a strong dollar on the dividend paying ability of a large company is modest. And, to the extent the strong dollar reduces inflation and interest rates in the U.S., the reduction in earnings is offset—in terms of the stock’s price—by a higher PE ratio, because the discount rate for valuing the stock is lower. (This was apparent in the Fed minutes released yesterday; the strong dollar and weak growth in Europe, which are closely related, gives the Fed more leeway to keep monetary loose.)
As an aside, a recent report from BAC reported that only 20% of fund managers were beating the S&P 500 so far this year. One reason is that—because their performance is evaluated annually—they have to try to react to things like currency swings, even though they cannot do it successfully. They just run up transaction costs and their clients’ tax bills.
Think Thematically
Forget about currency and save your brain power for something more important: Identifying long-term trends in the world economy and high quality companies that stand to benefit from those trends, enabling them to pay a decent dividend and to raise that dividend over the next decade. This is a two-part process:
- identify the trend
- identify the winners, as well as the losers you should sell or not buy.
Here I only do (1) by suggesting seven specific themes; for (2), talk to your broker or do your own research, in order to find good companies that really are leveraged to the theme. (Some themes are far more “investable” than others; it is hard, for example, to find stocks that are leveraged to the looming global water shortage.) Thinking thematically is not only a good way to identify stocks to buy; it is also a good way to identify stocks to sell and stocks not to buy even though they appear to be “cheap.” I also like thematic thinking because it gets you away from abstract “strategy speak” dualities such as high beta / low beta, cyclical / defensive, large cap /small cap, domestic / foreign; instead you are thinking about the “real world” — real businesses and what they do for a living, and how their prospects are affected by real world trends.
Why the Street Pays Little Attention to Themes
Note that many themes last for years and years. I first started writing about income inequality and the need to avoid the “mediocre middle,” such as department store chains, in the 1980s. The theme is still valid, especially with Obamanomics hurting the poor and middle class. Despite all the brain power on Wall Street, it does a poor job of identifying, and acting upon, themes. The most important clients, hedge funds, want short-term ideas with a “catalyst.” Wall Street thrives on “incremental information” – the “new news” that no one else knows yet, even if it is not particularly important news. A portfolio manager will hang up on a salesman who tells him that Nike is a good long-term play on the fitness craze and the emerging market consumer; that same PM will listen to the salesman if she says, “our analyst was on the road with the Nike CFO, and he seems more bullish on demand in China.” Analysts often ignore obvious themes – such as the fact that Coca-Cola makes you fat, so people will drink less and less as they get older — for a couple of reasons. For one thing, analysts are constantly talking to managements in the industry (who are chronically bullish), and to investors who own millions of shares of the stock. Another reason: analysts almost “have” to recommend something in their industry because they have clients who want to know what is their “best idea in the space” (in this case, beverages).
Seven Themes
More and Safer Rail Cars: The fracking boom and irrational government opposition to pipelines have vastly increased demand for rail cars to transport oil, as well as inputs such as sand. But oil-by-rail is dangerous, as shown by a disastrous accident that destroyed the Canadian town of Lac-Mégantic and killed about 45 people (the figure is approximate because some victims were vaporized). Regulators are belatedly demanding better / safer rail cars, both new ones and retrofitted cars. Apart from energy, demand for rail cars is robust due to strength in such areas as agriculture and chemicals (see below) as well as a shortage of drivers for long-haul trucking. This is bullish for certain industrial companies involved in making or rebuilding rail cars, as well as the railroad industry generally.
The Cloud Commoditizes Tech. This is one I don’t know much about. But basically computing power is shifting from individual customers having their own customized hardware and software (provided by companies such IBM, HPQ, ORCL, etc.) to the cloud – i.e., giant server farms. The server farms use huge numbers of cheaper computers, which threaten the margins of incumbents. (This is similar to the shift in the electricity industry in the 19th and early 20th centuries from every building having its own generator to buying power from a utility company such as Commonwealth Edison.) The shift to the cloud is good for some companies, bad for others. One implication is that some apparently cheap stocks will get cheaper and eventually go out of business. A smart hedge fund with access to the best Wall Street analysts could probably put together a nifty long-term long/short trade on winners and losers.
More pork and chicken with that rice. Chinese consumers want to eat better, which means eating more meat. But producing meat, whether chicken, hogs or beef, requires large amounts of feed such as corn and soybeans. That is bullish for the big agribusiness companies. The biggest U.S. export to China is not airplanes but soybeans. As the CEO of Deere recently noted, the profits of ag stocks have been hit by an unforeseen “extreme weather condition” – good growing conditions around the world, which have depressed corn and soybean prices. But strong Asian demand for corn and soybeans as feed for livestock, plus the likelihood that weather conditions will change for the worse, suggest that now is not a bad entry point for long term investors to buy the best global ag companies. They have strong franchises because of big R&D budgets, sprawling dealer networks, and close ties to farmers who are disinclined to take risk a growing season on new and unfamiliar suppliers of seeds, equipment, fertilizer, etc. Performance minded fund managers are scared of weather-dependent stocks, but long-term investors don’t have to worry much about the weather. A smart friend of mine who has worked for some of the best strategists and economists on both the Buy and Sell-side of the Street told me he is buying these names because they look cheap based on normalized earnings.
Spending More on Healthcare. This is a no-brainer, which suggests I don’t have a brain because I only acted on it in the past few months. Obamacare is taking money out of the pockets of tax payers and individuals who had what they considered adequate health insurance (and now have to pay much more for Obama-mandated plans) while funneling it to uninsured people who will spend more on healthcare. (For example, the health bills of 30,000 Wal-Mart workers are going up.) The trend is broadly negative for consumer spending but bullish for healthcare, which is the S&P 500 sector with the strongest earnings trends—both in the recent past and in analysts’ estimate revisions.
The Electronic Fuel-efficient Car. Whether or not they go electric, cars and trucks will contain more and more electronic content which will make them safer and more fuel efficient. It is ridiculous that new cars and trucks still have “blind spots” making it hard to change lanes; nor do they have automatic braking systems so that vehicles don’t plough into stopped traffic, creating catastrophic accidents such as the one on the New Jersey Turnpike that injured Tracy Morgan and killed James McNair. The new technology would pay for itself via lower insurance and litigation expense. As improvements are made, vehicles’ electronic content—the number of chips, connectors, wires, etc.—will increase, and so will demand for things like turbochargers that make them more fuel efficient. A buy-side strategist for a big firm told me he expects Apple to move into the vehicle space, which I had not thought of.
Purity Plays. In a rapidly globalizing world, Ebola is just the latest example of contaminants that governments, companies, and consumers need to monitor in order maintain health and safety. (Other examples: SAARs, AIDs, fake Chinese medicines, tainted meat, tainted fish, lead paint on toys, mercury smokestack emissions.) Companies that aid in that process, whether by producing lab equipment, sanitizing factories and hospitals, testing food for salmonella and e-coli, measuring / minimizing factory emissions, providing laboratory services, etc. will continue to experience strong secular demand. Around the world, government regulations to maintain purity are becoming ever more stringent.
Reconfiguring the U.S. (and Global) Energy Infrastructure. The fracking boom and rapid drop in oil and especially natural gas prices are making the U.S. energy industry—broadly defined to include oil refining, chemicals, plastics, fertilizers, LNG exports, etc.—extremely competitive globally. Eventually Washington will permit exports of oil and gas, something Tom Friedman recently recommended on economic and strategic grounds (we made the case last March). U.S. firms are building their new plants in Louisiana and Texas rather than Saudi Arabia and Dubai. Foreign firms, including giant German chemical companies facing skyrocketing energy costs at home, are also migrating to the U.S. gulf coast. U.S. industrial firms will continue to benefit from these trends.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
