Only a few years ago, investors heralded the potential in emerging markets. The sputtering of world growth has silenced that chatter. The miraculous possibilities of Asia and Latin America lie forsaken.
Meanwhile, none of that global potential has disappeared. The clock has been reset, opportunities deferred -- but the thesis still holds. Value investors love to find situations where short-sighted gloom veils long-term promise. In the classic technique of "time arbitrage," the value investor takes securities off the weak hands of those who can't (or won't) see the big picture. Given a longer time horizon, a return deferred by even a few years is justified if it yields an outsized gain.
In 2000, investors were positively giddy, ready to buy any chump stock at any dotty price. The halls were decked with false glory and glistening hype. That moment of unbridled optimism marked the worst possible time to go all in -- but that's exactly what most did.Now the psychology has reversed. After the most punishing decade in markets since the Great Depression, stocks provoke a singular revulsion. No one wants to own even a lone blue chip at 10 times earnings. Speak of global growth and the conversation slips sideways to the Euro crisis and Chinese overcapacity. Despite 50-year lows on valuations such as free-cash-flow yield, stocks fail to lure buyers -- who are far too scared of the next macro shoe dropping to bet even a dollar. Today's conventional wisdom is that Armageddon is nigh. Humans are guided unduly by their immediate experience, a concept behavioral finance calls recency. It's hard to divert our eyes from the spectacular crash in the rearview, but it's time to look to the road ahead.
The expectation of Euro defaults is already priced into shares. Cheap prices always occur as a direct result of macro concerns. The fear creates the buying opportunity. Even if the macro view is correct, visible concerns are largely baked into prices. But often the macro view is wrong. As the old saw goes, economic predictions make even weather forecasts look respectable. The unruly swamp of unknown variables and moving parts renders economic "views" meaningless.Show me an economist with a prediction, and I'll show you someone with a unique brand of hubris.
As Warren Buffett once put it:
"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen ... Imagine the cost to us, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist."~ Warren Buffett: 1994 Berkshire Hathaway Annual Report
To spot value in a given company at a given price is a task within reach. To predict the infinite permutations of a global economy -- well, I'll leave that to those who believe it's possible. Value investors must look past short-term problems.One way to put the Euro crisis in perspective is to ponder the remarkable value creation of the emerging markets. Consider that the four nations known as the BRIC's -- Brazil, Russia, India and China -- spawn half an "Italy" every year in terms of the additional $1 trillion they add to worldwide GDP.
Against all better judgment, I'll make my own misguided and useless economic prediction: Default fears will continue to roil markets in 2012, Greece will finally fold and Europe will enter a deeper recession. But once the fears recede, values will emerge. The counter-argument is often: Why not wait to buy until the turmoil has passed and the dust has cleared? The answer is that markets will have recovered by then; the stunning bargains will be long gone. The stock market discounts these expectations long before they show up.
When the Dow was at 6,500 in the dismal days of March 2009, I published a piece in the Huffington Post arguing that stocks were undervalued. It was a time of exceptional fear, and the analysis was understandably scorned. The comments I received were harsh and the emails harsher. This was reassuring. As a contrarian, I long ago learned to gauge the validity of my ideas by the hostility they provoke. The more, the better. If most people actually agree with you, you have a big problem, because then your view must be the conventional one -- already baked into stock prices. It's when people think you're loopy -- but you know you have valuation on your side -- that the big gains are waiting in the wings.
"Group-think" is the enemy of the investor; conventional wisdom is the absolute scourge. Philip L. Carret, the legendary money manager (and founder of the Pioneer Fund, one of the very first mutual funds) proved his contrarian nature by living until the unconventional age of 101. He famously said: seek facts diligently; advice never. I may undermine the very spirit of this investment letter, but I'll say it myself: always be wary of advice, stock "tips," or cocktail party chatter. If you fall prey to group-think, you've lost before you've even begun. Seek the facts yourself or don't invest at all.
I believe the best way to take advantage of the forsaken opportunities in emerging markets is through U.S. multinationals with large international exposure. Dow Chemicals (DOW) is a good example. Please see a detailed discussion of DOW by downloading the free new issue of the Folio here.
(Full disclosure: I've recommended DOW in my newsletter and I'm an investor in Insight Guru Inc., the parent company of Trefis).