Outlook & Investment Strategy: Three Themes for 2012
Measured by the percentage of large-cap stocks that have risen or fallen in sync with the S&P 500 index the correlation of individual stocks to the index itself reached record levels last month - 85 percent of the movement of stock prices was statistically explained by the movement of the S&P 500 index (see chart).
In a high-correlation environment there is generally not much room for investment analysis and securities selection since stocks tend to move in tandem with the market. But over time such high correlations create tremendous stock mis-valuations, creating rare and unique opportunities for long term investors.
Financial Crisis & High Correlations. RBC Capital Markets issued a report last month on the impact of high correlations on active portfolio managers. They note the upward trend in the correlation between individual stocks and the S&P 500 index over the last several years (chart at right), and the recent record levels of correlation.
The RBC report concluded at least three factors contributed to these trends: (1) the increase in global trade and economic interaction, (2) the increase in program trading, and (3) the huge surge of ETF’s which are used by some for short term trading purposes. Charts of these trends are striking:
High correlations have historically been associated with a market crash or crisis during which all stocks tend to move the same direction. For example, during the ‘Crash of 1987’ individual stock correlations with the S&P 500 index reached 80%. Given the severity and the brevity of that decline, the high correlation was not unexpected and quickly declined.
After 1987, the rolling correlation of stocks to the S&P 500 rarely exceeded 60% until the financial crisis of 2008 – now it is common for the correlation to exceed this level (see chart at top of page). (Charts courtesy RBC Capital Markets)
The RBC study suggests active portfolio managers in a high-correlation environment adopt strategies (1) reducing the number of holdings in their portfolio, and (2) placing a greater emphasis on sectors that might generate excess returns. Concentrated portfolios with fewer stock holdings are more likely to have lower correlations with the overall market according to the RBC data.
Investment Strategy: Kelly Formula & Exponential Portfolio Growth. Charlie Munger, Warren Buffett’s investment partner, developed an investment discipline where he would only invest in the stocks if he had a substantial chance of obtaining excess returns. Munger notes that one of the most challenging issues for investors is having the patience – and conducting the due diligence – to find situations where they have a substantial statistical advantage.
When individuals find a situation where they have an edge they should scale their investment to reflect the applicable risks and rewards according to Munger. When a large positive outcome has a high probability of occurring the investor should invest heavily. When the odds are not heavily tilted in the investor’s favor the investment stake should be scaled back. If an individual does not have an advantage, or edge, they should not invest.
Using this proportional investment strategy, sometimes referred to as the “Kelly Formula”, academics have shown that an investor should experience exponential portfolio growth - well in excess of the market averages. Munger and Buffett, as well as numerous others, have shown this strategy has practical application when investing real money.
Actively managing stock portfolios early in their careers Munger and Buffett adopted strategies similar to the Kelly formula. Both managed highly concentrated portfolios. Early in their careers they also focused on very small companies where they could develop a statistical advantage. They invested in undervalued companies with growth characteristics. When small companies were mispriced by the market they invested heavily. Over time their returns were ‘exponential’ – as predicted by the academic studies.
LSGI 2012 Strategy. Due to the high market correlations and volatility, in 2012 we will seek to limit our investments to sector themes we consider extremely attractive. These are situations where we think the risk/reward relationship is tilted heavily in our favor. We have found three sectors that we think will be very attractive for investors. We discuss the investment themes below.
Sector Theme #1: Global Agriculture
A number of very positive long term global trends are in place in the agricultural sector. Farm incomes in the U.S. have rocketed to record levels – great for firms that sell agricultural related products or services.
The U.S.D.A. forecasts U.S. farmers’ net income rose to $100.9 billion in 2011, up nearly 30 percent from 2010, reaffirming the bright spot agriculture represents in an otherwise gloomy global economy. This would be the first time ever that net farm income was above $100 billion. Farm income is expected to continue to grow in 2012.
Agriculture will be one of the major sector themes in our portfolio in 2012. Recent presentations by some of the larger companies in the sector, and USDA reports, paint a very positive picture of current and future trends.
U.S. Farm Economy – The U.S. farm economy has been very strong, with cash receipts and farm balance sheets pointing to a very healthy business environment:
(Charts courtesy John Deere Co.)
Farm income and capital expenditures correlate very closely over time – and with record farm income we would expect robust capital expenditures in 2012:
(chart courtesy of Agco)
Further, the Creighton University Mainstreet economic report indicates that the farm equipment sales index continues to expand. December’s index reading was one of the most bullish in years.
The Creighton farm equipment sales index has indicated the sector has expanded for 22 straight months (index readings over 50 indicate sales are expanding). A chart of the data illustrates the expansionary trend.
Global Agricultural Trends – Long term global trends point to growing populations, increasing demand for grains and protein, tight inventories, and agricultural prices that are well above historical norms.
(charts courtesy of Agco)
World grain consumption has exceeded production in eight of the last twelve years, and the global inventory stocks-to-use ratio has declined substantially over the last 25 years:
With increased global demand prices for many agricultural products have increased to levels well over historical norms – increasing farm profitability. High commodity prices are a major reason farm income is at record levels:
(Charts courtesy Potash Co.).
Meanwhile the supply of arable land per capita is declining, which is one factor that tends to limit the supply response to higher agricultural prices. (Chart at right courtesy Monsanto)
Alternative Fuel Programs – In addition to increasing demand for agricultural products due to growing global populations upgrading their diet, a large and growing segment of the agricultural sector is focused on providing products for use in the alternative energy space. In the U.S. legislation has mandated, and subsidized, the production of agricultural based alternative fuels.
While the bulk of alternative fuel use is driven by U.S. markets, the increasing use of ethanol is a global trend – which is positive for the corn market. (charts courtesy John Deere Co.)
Sector Theme #2: Global Crude Oil
Energy will be another major sector theme of our portfolio in 2012. Global demand for crude oil, led by developing economies, continues to rise. Meanwhile the Arab Spring and production difficulties have restricted increases in global supply capacity, leading to higher prices.
The International Energy Agency (IEA) cut their crude oil demand forecasts for 2011 and 2012 – but both years are still expected to show robust demand growth.
In 2011 global demand is forecast to reach 89.0 million barrels per day, up 0.7 million per day over year earlier levels. For 2012 demand is forecast at 90.3 million barrels per day, up 1.3 million barrels per day from 2011 levels. Both will be record levels of consumption. The chart above from the Financial Times illustrates the relentless growth in global demand.
U.S. demand for crude oil has remained relatively stable over the last few years as the economy has grown very slowly. The incremental demand growth is from developing countries, as illustrated in the accompanying charts from the Wall Street Journal.
With global demand increasing, and supply issues arising from the ongoing Arab Spring, the price of crude oil has performed very well. As oil prices push $100 a barrel many exploration projects become economically viable that otherwise would not be developed. Crude oil inventories in Europe are now at 11 year lows.
We think the political disruptions in the Middle East and North Africa will be more severe, and last longer, than most analysts expect. Investments in existing or new prospects will fall short of expectations until (1) stable governments are installed that (2) articulate stable development policies and regulations. Those investing the massive amount of capital required for many energy projects, as well as those firms supplying the technical expertise, will hesitate until these pre-conditions are met.
Sector Theme #3: European Natural Gas
U.S. natural gas producers are facing a glut of supply and a mild winter, driving prices down to levels not seen in years. Not so in Europe, and specifically Poland, where natural gas is selling near $10 a thousand cubic feet (mcf). Spot prices in the U.S. are currently around $3 a mcf. (Chart at right courtesy FX Energy)
The reason for the high prices? Europe imports 50% of its gas supply from Russia. Natural gas prices are tied to crude oil prices under the sales agreement. Poland is even more dependent than Europe – they import around 65% of their gas supply from Russia.
The U.K. North Sea was a major natural gas exporting area until around five years ago. Due to depletion the U.K. is now a major natural gas importer. Development of natural gas shale plays in Europe are well behind the U.S., and in some European countries hydraulic fracturing is banned.
Poland is also unique in that it has not been explored and developed to the extent seen in fields in Western Europe and the North Sea. Under communist rule natural gas was imported from Russia. The one state energy company in Poland did very little exploration. Seismic technology and digital analysis were a decade or more behind what was standard in the U.S.
Summary - Investment Strategy 2012. Bottom line for 2012 is that all the firms in our portfolio are (1) situated in attractive sectors, (2) growing, (3) profitable, (4) undervalued, (5) small and overlooked by analysts/investors, and (6) positioned so that the risk/reward ratio is tilted heavily in our favor. High correlations or not, over time the underlying value of these firms will be recognized.
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