Most Popular ArticlesNovember 17, 2009
Which assets give you the best overall protection?
The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.
When you have a set of positions, you are looking for a discount to intrinsic value, but after you’ve built that portfolio you want to know that it is reasonably balanced. Fortunately, at the moment, the best bargains are in franchise businesses. You are getting 8% to 11% and in some cases 13% to 14% sustainable earnings returns. With no growth at all, you have a safe asset with really attractive returns in selective areas.
People have learned to look at their portfolios with this degree of balance as a result of this experience. Realistically, I don’t believe in inflation in this environment, but nobody can be absolutely confident of what will happen with respect to price expectations and inflation.
We’ve learned about diversification, the cost of leverage, looking at our portfolios from a macro perspective, and looking for balance in our exposure. The other thing we did inadvertently, when our macro exposure looks to be too much for the balance of our portfolio, is to think about buying hedges. The hedge that we’ve had is gold, which has protected us. The attractive thing about gold is that it has no industrial uses. It’s strictly something that, when everything goes wrong, it’s going to do really well. I think people have learned to appreciate that.
The other great way to hedge is to recognize that when the risks are the biggest is when nobody thinks there are any risks at all. When that’s the case, the implied volatilities in derivatives are going up, and you get really good prices on deep out-of-the money puts on overvalued indices like the Russell in the summer of 2007, and you get really good prices on credit default swaps. You can buy credit default swaps that are trading at four basis points, which implies one default in 2,500 years – in the most volatile region on Earth or on the most volatile commodity. Mutual funds really can’t use this strategy, but good value funds are thinking about hedges, which are really forms of insurance. For the last several months, hedges have been extremely expensive, but they are finally coming down in price.
In our mutual fund, gold is the primary hedge. We have some cash, which is clearly a safe asset carrying a low yield. Most of our risk management is that we are consciously moving our portfolio – because that’s where the bargains are – to the areas where we believe the macro risks are considerably more attenuated.
What surprised you in this environment?
The biggest surprise, in a funny way, is the way that franchise companies, like Deere, have weathered this period in terms of their profit performance. The auto companies got slaughtered, but Deere, which typically would have gone from making money to losing money, is maybe down 35% in earnings.
These companies increasingly make their money on services. The part of the package you need from Deere, if you own a Deere tractor, is service. If it breaks down, you need it fixed. Deere has a dense network of dealers with lots of parts availability and lots of capacity. You’re going to get much better service and you are going to get a higher price for that. That’s a competitive advantage that protects them against price competition. As the package of what these manufacturers offers moves in the direction of service, they are going to have more local monopoly power in different areas, because the services are locally produced and consumed.
Some of the stocks you own, like Microsoft and American Express, don’t fit the traditional mold of value stocks – ugly, cheap, beaten-down, and boring. What makes these stocks attractive?
American Express is unbelievable. It has sustainable earnings of a minimum of $3/share. If they manage their costs at all – and that could happen if Ken Chenault leaves the company – they could easily make another $2.50/share pre-tax by cutting costs. You’re talking about making $5/share after-tax in sustainable earnings. When the price is $10, that’s two times earnings – a 50% earnings return.
If you think it is $3 or $3.50 with a potential of $5.00, you’re talking about an earnings return on American Express that’s 10% and up. They’ve got some organic growth because they earn 1.1 % on their billings [through merchant fees] without any significant impact on receivables. Rich people are clearly doing better than poor people, as they have for the last 40 years. The surprise is that these stocks, which you would not think are ugly or obscure, are this cheap. People have just gotten scared.
Microsoft is going to rule, because you need an operating system. They have pricing power. I don’t know why their stock was at $17, which I believe is where we bought it. They generate huge amounts of cash. Their stupidity seems to have stopped for the moment. They are not doing X-box or dumb things for Yahoo any more.
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