Falling Out the First Storey Window
Since the February 27th fall in the Shanghai market, there has been some contagion in markets around the world. Like Butterfly theories of the global economy suggest, popping of speculative bubbles elsewhere in the world can have a profound effect on other markets. The psychology of speculation and sudden awareness of misallocated capital creates fear and destroys rational thinking. As is usual, the break in the Chinese market had no specific trigger, no new revelation, and no single disturbing statistic that prompted this change in thinking. As is also usual, most internationally bound capital starts seeking domestic shelter.
There is minor evidence of chastened thinking. One of my favorite brokers had turned down my firm’s global investment unit trust in January because it was too conservative and reflected economies with insufficient growth. He pointed out a chart showing Japanese and European economic growth at the low end of world growth forecasts and well below that of BRIC economies. My investment trust is down a fraction; his choice is down about 9%. Now, I learn that he is calling me in for a separately managed account for one of his “aggressive” accounts who has become interested in safety of principal.
For the most part, there is a fair amount of complacency and “seen this before” attitude in capital markets. Most of the “Average Joe” investors that I have spoken to seem to believe that the market always comes back and over the long run, you can’t lose. I spoke to one high net worth fellow yesterday, a fellow with most of his invested wealth in hedge funds who believes that he faces little risk with his Blackstone managed private equity funds. Perhaps, we in the investment industry have done too good a job in teaching people not to panic. Perhaps, we are all deluding ourselves as to the risks.
I have always maintained a truism that the economy per se has nothing to do with the stock market, the biggest factor is what price you pay and what level of profitability you are attaching yourself to. Historical profitability is an important factor in analysis but of far more importance is a sense of the competitive advantage period. Finding companies that can earn substantial profitability behind the protection of a sustainable competitive moat is always the mission. Being able to do so when the world is dying to get out is the tactical advantage we seek.
I had hoped for better prices. Ordinarily, I love to be in the position of sifting through wreckage following a substantial correction. Unfortunately, the Chinese “accident” was more of a scrape or a fender-bender than a full-fledged crash...a fall out of a first storey window. The grave-dancer in me would love to see a little more stormy weather hitting the emerging markets. Streams of income from risky third-world countries provide insufficient compensation at this point to warrant the risk. But streams of income from highly leveraged companies in a private equity pool also should demand higher compensation. Fear and a sense of terror do not seem to be out there. Fear is the main source of superstition as Bertrand Russell said and taking advantage of it can be one of the best elements in buying great stocks cheaply.
Risk aversion unfortunately tends to get thrown out the window by higher rather than lower prices, by exotic instruments rather than traditional ones, and by mystery and intrigue!
Risk aversion was defenestrated in the Internet phase of 1999 and 2000. Despite wonderful opportunities that existed in the decent stocks that were being dumped to provide the fuel to accumulate the crap, the desire for more risk overwhelmed most investors. Boring and decent was traded for excitement and lure. On the other side of the bubble, fear overwhelmed many investors. Of all passions, fear weakens judgment the most.
The willingness to undertake new, unproven, and risky investments remains very high at the moment. The skepticism and apprehension that ordinarily causes vacillation and reluctance in many investors also seems to have gone by the wayside. In short, when it comes to hedge funds, to private equity funds, and to buyout funds, the usual insistence on high risk premiums is absent and the willingness to accept greater risk is strong.
Mr. Market has provided us with a few bargoons in the interim. I like Legg Mason (LM) at current levels and continue to believe that 3M is cheap following the value-enhancing buyback that management proposed shortly after we published our recent note (we are not so arrogant to believe that this action was in any way other than fortuitous timing) I am also intrigued with Barclay’s Bank (BCS ) at current levels. I will write up my views on Barclays shortly.
Disclaimer: I, my family, or clients have a current position in LM, MMM, and BCS.