Questions and Answers

The mailbox issue last summer elicited so much positive comment that I have decided to do it again. Of course, trying to answer inquiries generates more inquiries, but such is the give and take in the investment business. I have made a good living asking the right questions at the right time and there is no reason why I shouldn’t respond to same. Here are three recent communications that I thought deserved a published response:

John: I know your heavy weighting on international investments have been good for returns, but is there a larger message there about the U.S. and its long term economic prognosis? Is this just some cycle, or are there some larger forces at work and how does China fit in?

There are larger forces at work, and most of them can be attributed to the fact that the economy is truly global. In many sectors (think autos, steel, apparel manufacturing for starters), the leading companies are in Japan, Korea and China. And there are great competitors in Germany, the U.K. and South America. The real issue is that non-U.S. companies have become better than us in a growing number of areas, and therefore, have been growing at a faster rate than their U.S. counterparts. The big picture is eye-opening:I know what you are thinking—hey, we beat Slovenia! The more interesting question is why the two giant economies, China and the U.S., are at the bottom. The short answer, which has been an investment thesis here, is that these two countries are in economic transition—one emerging, one trying to hold on as a world power. Investors do not like uncertainty and that is what you get with these two nations—thus our long term U.S. underweighting and our outright avoidance of Chinese stocks. Will China solve its corruption, pollution and inflation problems as it grows? Will the U.S. renew its manufacturing base, improve its savings rate and solve its pension and healthcare issues? Until we get some clarity on these concerns, then international ex-China (we like companies in Singapore, Taiwan and South Korea doing business there) and mostly ex-U.S. (we still like large cap U.S. companies in global businesses) will be an investment driver for us.

John: You have said in the past that the U.S. dollar decline is a long term phenomenon. I just got back from Europe and could not believe the exchange rates. How low can we go and why?

Well, I think we know how we got here—the U.S. is a net debtor; we import more goods than we export and our government runs large deficits. The truth is the U.S. is not a good credit risk compared to other, less encumbered, economies and our currency reflects that:How much lower? Well there is one major floor to examine, and that is the dollar’s status as the world’s reserve currency. Governments and investors tend to flock to our treasury market in times of crisis, and major industries (oil) and important governments (China and Mexico) do business in dollar terms or have their currencies pegged to the dollar. Many have speculated how long this will last—foreign investors are starting to diversify their holdings and countries in the pan -Arabic region are starting to enter into non-dollar oil transactions. The many problems that plague the U.S. economy are not going away without some significant industrial innovation, changes in government spending policies and radical overhauls in energy and pension/health care policy. As my kids would say, “Well... good luck with that”.

John: Our oil related investments have gone way up—surely it must be time to sell some.

Even though we may have a short term drop in these investments if we have a U.S. recession in the next 18 months (a good possibility), we would be inclined to stay the course. Long term, global demand for oil-related products are outstripping supply and there are many companies that we hold that will do very well in that environment. Many companies in the oil services and equipment business can make good money at $35-40 oil, and I believe the supply/demand dynamic has prices going higher than that:

There are always many more questions than answers, and every business contains predictive elements. Asking good questions and assessing the answers properly is the best way to help your odds in this one. The answer to one such question I asked in the January newsletter on volatility has been featured prominently in this year’s market. Still, we see few changes to our strategy-- global growth is still solid, despite the travails of the U.S. credit and housing markets. Will there be a U.S. recession because of these troubles and what would the impact be on world markets? Those are good questions...

My best to all,

 

John III