Which Lesson?

January 13th, 2012

Dear Investor:

The smallest year’s change in the S&P 500 since 1950 hid its fair share of intervening chaos. The index ended at 1257.60 after starting at 1257.64, a statistical journey to nowhere. But the chart shows the high drama, with the market first rising, then declining 21% and reaching an intraday low of 1075 on October 3 before rallying 17% to close the year right where it began:

1/11/11                                                                                    12/31/11

Is there a lesson here? I would say the moral is to never time the market:. At the cusp of Sept/Oct when investor anxiety over the Euro reached its pinnacle, many bailed out of stocks, thus creating the bottom. It was precisely at that point, when the downside appeared huge and the upside limited, that exactly the opposite was the case. As it so often does, the market confounded all expectations. Anyone who sold in September ended the year with a pitiful loss.

No doubt others will draw different conclusions – perhaps that a trading strategy (that sold at the July highs and bought back at the exact October low) would have been anything other than luck. I believe predicting the short-term direction of stocks is the type of magical thinking best left to shamans and fortune tellers. For some reason, looking into a crystal ball to predict markets is deemed semi-respectable (cloaked as it is in macroeconomic mumbo jumbo) – while the person who “predicts” red on the roulette wheel is rightly written off as a charlatan. Anyone who says the market will go up next month is proclaimed a genius when it does and an idiot when it doesn’t. This is like congratulating the gambler who correctly guesses red and haranguing the one who incorrectly bets black – when the only logical response is to say: stop gambling.

The lure of speculating in markets, or reacting to the latest macro event, is very compelling. But the best money managers from Buffett on down have always been value investors – those who ignore market predictions and instead focus on buying undervalued assets.

Getting back to value, where are we finding it? In the quest for good deals, we often swap from asset class to asset class, not to time the success of any particular one, but instead to seek underpriced securities (as measured by a discounted cash flow valuation, price-to-cash ratio or combination of other metrics). Said differently, we know the what but not the when — we know that the asset class will return to favor, but it could be next month or next year, or even three years.

Today the cheapest asset classes in the world are U.S. large cap multinationals, European equities, and Japanese equities. The most expensive are U.S. Treasury bonds, gold, and other non-industrial commodities. There are so many good companies trading at distressed values (precisely due to macro fears) that it’s the kid-in-the-candy store problem for any portfolio manager. The average p/e ratio on Euro equities is 9/1. Relative to interest rates, stocks just don’t get cheaper than this. As Bill Miller of Legg Mason said recently, everything except the complete obliteration of Europe is already priced into shares.

Sometimes value can be difficult to discern. On November 30, we sold the EWJ, the Japanese stocks ETF at a price of $9.37/sh after buying it at $9.92 on March 15 — in the wake of the Fukushima nuclear disaster. We swapped from the EWJ into another Japanese ETF, the DXJ. It must appear stupid to sell something at a 5.5% loss so soon after buying it, especially since I just said Japanese stocks are dirt cheap. So why did we do it?

The answer lies in the underlying appreciation of the Yen. The EWJ doesn’t hedge currency exposure. Over the past year, the Yen appreciated 9%, from a low of 85 yen to the dollar. When dollar-based investors own Japanese stocks without a currency hedge, their fortunes rise and fall with both the stock price and the Yen. The underlying value of the EWJ decreased due to stock declines, but also increased due to currency appreciation. The net result was a loss since the decline of the stocks exceeded the appreciation of the Yen. But the appreciation of the Yen cushioned the overall decline substantially.

I believe the Yen is now overvalued while Japanese stocks are even more undervalued. The solution was to swap out of the unhedged EWJ into the DXJ, a Japanese ETF that hedges it currency exposure. By doing so, we participate in any appreciation in cheap Japanese stocks while being protected from declines in the Yen. I normally don’t like hedges, believing them to be expensive and often ineffectual. As David Einhorn says, the best way to hedge against something is just to sell it. But this is a case of one half the investment (the currency) being unattractive while the rest of the package remains compelling. A hedged ETF is really the only way to unlock the value in Japanese stocks for a U.S. investor. We still own some small positions in Japanese mutual funds that are unhedged to the Yen and are looking into selling those as well.