Today’s Opportunities: Japan and Emerging Markets
October 5, 2012
People often speak of “the market.” This connotes a monolithic stock market and implies a binary choice: buy or sell (all) stocks. In reality, the market is composed of thousands of stocks, multiple sectors, and tens of subsectors. The number one question people ask is: what will the market do? But the question should be instead: where are today’s opportunities? Rarely (if ever) is the best choice to sell all stocks and sit in cash trying to trade around some heralded collapse. Professional value investing is the constant process of selling what’s dear in order to buy what’s cheap, forever hunting the highest expected risk-adjusted return while ignoring macroeconomic and market “predictions.”
There are always cheap stocks (or bonds) or other asset classes – gems that have been forsaken by traders due to temporary hiccups – that the value investor can snatch up. These bargains often go down when the market goes down, but that should not concern the patient owner because expected returns are high. Eventually, they will reward the buyer. To the untrained eye it appears that the market goes up or down en masse. Lurking beyond the indices, however, are vastly different scales of returns over 5-year, 1-year, 3-month and even 1-month periods.
Just as bargains always await, it follows that there’s a lot of overpriced merchandise out there, over-owned as the fashion of the day. At one time or another, nearly every sector enjoys this irrational exuberance. In between, however, there are the sectors that have reached full value, neither too pricey nor to cheap. Those are the tough ones.
The homebuilders are there now. We have owned the homebuilders for nearly two years. I bought the ITB (an exchange traded fund or etf — a basket of stocks, in this case housing construction companies) back in November of 2010 when the prevailing wisdom was that housing was dead – and would be forever. This macroeconomic prediction, right or wrong, didn’t matter to us, given that homebuilders were trading at free-cash-flow yields of over 10% at the time. Our thinking was if housing got worse, that news was priced in. And if housing got better, we could make a lot of money. Given the pessimism that shrouded the sector, the price was truly right. In the end, all home prices had to do was stop sinking – which they did – leading to large stock gains in the sector. Today, the ITB is at $20.23 per share, nearly 70% above our purchase price of $12.14.
Now that the market has broadly recognized the housing recovery, however dim, the stocks are no longer cheap. Trading at over 20 times free cash flows, the homebuilders look fairly valued. We have just sold approximately half the ITB position in client accounts (subject to tax consequences) and plan to sell more if they appreciate further.
The new opportunities lie elsewhere: especially in the emerging markets, which look cheap for the first time in years. With the proceeds of the ITB sale, we are building emerging market positions, buying the Schwab Emerging Market etf (SCHE). This etf owns companies such as Taiwan Semiconductor, China Mobile, and PetroChina, as well as Latin American companies like Petrobras, and Indian companies like Infosys. At 11% free-cash flow yields on average, these decent growers look compelling.
On the negative side, Japan has been a big disappointment so far. The Japanese market seems to perennially disappoint investors, having been mired in a secular bear market for 20 years. Our Japanese etf, Wisdom Tree Japan (DXJ), which owns companies such as Canon, Honda, Mitsubishi and Nissan, has only returned 1% year-to-date – a truly pitiful gain against a backdrop of double-digit returns from many other sectors.
But I am not ready to give up on Japan. Japanese equities are trading at a 14% discount to their book value, or liquidation value. I have never seen stocks this collectively cheap anywhere, at any time. Just like the homebuilders, they are so cheap that they will have to rally at some point regardless of the macroeconomic climate. And if Japan just regains some minor inflationary footing, we’ll do more than alright.