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STILL UNDER-OWNED II?

With the world watching Mr. Putin and the new Ukrainian government, one can’t help but be concerned with the Emerging Markets and their vulnerability to geopolitical winds.

In trying to get my “head around” this Ukrainian issue, the logical thought processes all lead back to one conclusion: “Buy the U.S.A.” In January 2013, we identified several reasons to focus on U.S. equities rather than alternative asset classes. Today, 14 months later, these reasons are still valid, and several new arguments have emerged to further strengthen that case. I hope to now refresh our thesis with the added benefit of hindsight along with some (just a little) reiteration.

Certainly the world is not all rosy and risk free. Rather, the world is seemingly adrift in a sea of ambitious “crazies” without any hint of responsible leadership in sight. While China “faces off” with Japan over a rock island in the Pacific, Mr. Putin “faces off” with the new Ukrainian government over Ukrainian assets. The “Mullahs” in Iran keep moving toward their nuclear bomb, while North Korea bathes in the delight of dreaming up more sick atrocities to bestow upon its citizens. The streets of Caracas are alive with rebellion, as the new Venezuela dictator tries to take charge amidst a deeply troubled economy. Need we mention Argentina… or the Brazilian recession… or worse, the slowdown in China? The jury is still out over “Abenomics” and whether the combination of taxes and printed money can lift the Japanese from the near 30-year doldrums of deflation. In France, the new wealth tax invoked by President Hollande is flushing French wealth into rare art forms that can’t be traced by government, rather than into positive investments. In Syria, Assad continues to kill his constituents, and the Muslim brotherhood is alive and well in Egypt.

So, somebody please tell me about the advantages of investing in lesser developed countries. Yet Americans continue to rush overseas as most of the investment community recommends. The last number I saw reflecting the amount of U.S. dollars invested overseas was something close to $16 trillion. If one-fourth of that stake tires of losing value through currency exchange rates, let alone the many other geopolitical risks already mentioned, what effect will it have upon the value of our dollar and U.S. markets if it returns home? After all, there is only one Exxon Mobil, Intel, or Johnson & Johnson to buy.

fIt is our belief that recent market strength may be coming from those who see the “folly” of chasing growth overseas and are instead taking advantage of the many American opportunities right under their noses.

Using the word many brings to mind the fact that there are fewer (by 31%) public companies in the Wilshire 5,000 than fifteen years ago. There are simply fewer stocks to buy. If demand for public companies picks up, prices will definitely rise. This new found demand need not simply come from repatriation as there are other imbalances to consider. Yield investors, having gone to bonds over the last few years could see the value of their bond investments evaporate if our economy gains any kind of traction. We believe this may be happening, albeit very slowly. Bond and annuity investors may begin switching when they get their tax bill in April. Corporate dividends are subject to lower tax rates than interest income from bonds. Lower tax rates combined with lower bond prices could well bring another stream of equity investors into the markets.

Our research sources tell us that Pensions and Endowments are still under-allocated to equities. Normal exposure to equities has traditionally been approximately 50%. The current number still stands somewhere near 35% after being as low as 31% a year ago. Plan sponsors and trustees have increased alternative investing instead, seeking lower volatility. Typically these alternative investments end up in private, new, non-liquid vehicles, hence the lower volatility. Ultimately those opting for lower volatility are trading for less liquidity, offering the rationale that they are all long term oriented. Yes, it may indeed take them a long term to sell these investments to raise needed cash. Hopefully they too will “see the light.”

So, you see, we are quite favorable on the supply/demand equation for American equities. Our search for individual companies is quite focused because we believe that selectivity is even more crucial today than ever. We don’t want companies with financial leverage because an interest rate reversal will impose severe cost increases for debt service upon them. We also want to avoid companies that are exposed to government control or regulation. As the political environment in our country changes, there are more and more companies exposed to this risk. Consequently, we are on a constant search for sectors and companies that can avoid these headwinds. We have identified several that have not yet been added because of price or short-term earnings risk.

Over the last 5 years, corporate profits, as measured by the Standard & Poor’s 500 Composite, have risen 117% while revenues have only increased 7%. Clearly, companies have eliminated costs and grow through expanded profit margins, but this can’t continue forever–or without negative earnings surprises. Consequently, we continue to be very deliberate and careful when picking stocks. As always, the macro-economic picture will ultimately dictate the direction of things.

Our hope is that the economy gains traction, giving earnings momentum to the majority of companies. This, in turn, should create demand from overseas and institutional investors, as well as yield conscious investors. If timed properly, these events could precipitate a “melt-up” in stock prices. The ingredients are all there, but before I get too euphoric, I have to stop myself and caveat these comments by saying that this is not a projection, but rather just a possibility; perhaps the best set of conditions leading to such a possibility that we’ve seen in a long time. It would be fun, wouldn’t it?

Here is an article recently featured in Forbes magazine that I hope you enjoy.

About the Author


Harlan J. Cadinha
Founder, Chairman and Chief Strategist
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