Author: subir

2014 Themes: Use Extreme Caution

2014 Themes: Use Extreme Caution

Dear Friends,

We’d like to start off by wishing you a very happy and healthy 2014. We trust you enjoyed the holiday break with family and friends.

At the beginning of each year, we put together a list of our top 10 investment themes and predictions for the year ahead.  We’ve done this now for four years, and our fifth installment is enclosed. We hope our perspective helps inform your view of the current and future investment climate.

We’ve also graded ourselves on our 2013 themes: we were wrong on one, right on seven, and are giving ourselves half a point for two. Eight out of ten is a very good score in the investment world. However, our celebration is tempered by the fact that we were rather wrong on our call for equities. Developed market stocks performed very, very well in 2013 with the US leading other markets.

That has not deterred us from applying our value methodology to equities in looking forward. We continue to caution investors to be wary of US stock prices which are currently rather high.  For most investors, we would recommend a moderate underweight towards stocks in their portfolio, but there are other ways to implement a cautious view towards equities.

The New Year also brings with it an opportunity to make decisions on certain tax and retirement plan issues. We encourage clients to think about the following, and we are happy to discuss them in more detail:

  • If you haven’t already, this may be a good time to put together a household budget for 2014.
  • Review your 401k contributions for 2014 to confirm you’re saving enough for retirement.
  • You have until tax day to make a 2013 contribution to an IRA. The limit for 2013 is $5,500 ($6,500 if you’re over 50).
  • If your financial plan is at least two years old it may be time to revisit it along with your will, life insurance and other long-term financial documents.

We hope you have a chance to review our themes for 2014. We look forward to speaking with you to review your accounts for the start of the year and we’d be pleased to address any other questions you might have.



Louis Berger                                                                                        Subir Grewal



  1. The bond decline continues: 2013 was not a good year for bonds, particularly longer term (20+ year) bonds which saw double digit losses.  With the Fed’s announcement that “tapering” (aka stimulus removal) will begin in January, market participants should brace for higher rates/yields and lower bond prices.  While we don’t foresee a rapid rise in rates (the Fed should be able to prevent a shock), we think the trend will continue.  The 20 year treasury began 2013 at 2.63% and ended the year at 3.70%.  We wouldn’t be surprised to see it exceed 4.50% by the end of 2014.  If it approaches 5%, we think it would provide a good entry point for investors to begin taking positions in longer dated bonds (10+ year maturities) again.
  2. Equities: Last Call at the QE punchbowl: The US and global equities rally has been underway for almost five years now and US indices have roared back, setting all time record highs in 2013.  As most market participants know, the economy, while improving has not done most of the heavy lifting.  Stocks and earnings have benefitted most by the easy money/stimulus policies of the Fed.  Ben Bernanke’s era as Fed Chairman has come to a close, but not before a pre-announced reversal in policy as the Fed attempts to unwind their QE program.  This will likely cause interest rates to rise which will create a tougher earnings climate and contracting PE (Price-Earnings) multiples for most companies.  These will put a lot of pressure on stock prices.  With multiples at cyclical highs, conditions are ripe for a significant correction, especially in US markets. We advise investors to avoid complacency and prepare for a potential 20%+ correction in 2014.
  3. Bitcoins backlash: 2013 saw the “virtual currency” bitcoin garner a great deal of interest, and publicly-announced investments from some high-profile personalities. In our view, bitcoins are no different from tulips in Amsterdam during the early 17th century.  They are the latest incarnation of speculative manias that invariably end in tears.  What sets bitcoins apart from the South Sea Bubble, Railroad mania, Florida Real-Estate and even Tulip Mania, is that the speculative premise is even more unlikely than all prior episodes.  Bitcoins are generated expending the same sort of worthless effort that gold miners do when mining gold from underground veins, refining it and storing it back in underground vaults. The entire process adds no value to human life except for those amongst us who gain intrinsic satisfaction from knowing some dull, heavy, yellow metal is being held on our behalf. Perhaps the one thing we can say about bitcoins is that mining them does not result in the terrible environmental impact that mining gold does. Despite the concerted efforts of many conspiracy theorists, we do not see a major reckoning for fiat currencies in the offing and therefore continue to caution against allocations to alternative or commodity based currencies.
  4. Social Media Mania: 2013 has seen a handful of very high profile IPOs from social media companies.  Some of these companies have minimal revenues and in many cases no prospect of increasing them without significantly degrading the user experience.  Numerous companies are trading at stratospheric P-Es above 200. We are long-term believers in the transformative potential of technology, but do not believe current valuations are anywhere near reasonable. Investors will have to be a lot more selective in 2014 if they are to avoid the kind of fall we saw in the early 2000s. We expect to see several of these high-flying tech IPO darlings come back to earth this year.
  5. Go Global or Go Home: One of the defining characteristics of the telecommunications revolution of the past two decades is that the world has never been closer.  For the first time in history, a large portion of the human population, particularly the elite, richest sliver, consumes the same media. Baywatch was the first globally syndicated show watched across the world for its universal appeal and it first aired 25 years ago. For US investors, this globalization represents an opportunity since the world is largely consuming American media (particularly when it comes to children’s entertainment). We believe media companies with strong properties are on the cusp of another period of growth in market-share. At reasonable valuations, they represent an attractive long-term investment.  At the same time, we believe strong regional, cultural media properties will also find traction in their home markets and any areas with affinity.
  6. Commodities Wane: Commodities, for the most part, have been in a relatively flat holding pattern since the 2008 bubble.  We expect commodity prices to remain weak or stagnant throughout 2014. We do not anticipate large rises in economic activity in the offing, which means commodity prices will remain depressed.  We do not expect gold or other precious metals to recover and anticipate further declines.
  7. Wages and Profit: The past few years have seen corporate earnings rise while average wage income has stagnated along with labor costs as a portion of GDP. We expect 2014 to reverse some of this trend as a declining unemployment rate and an evolving political climate make for higher wages and a higher minimum wage floor. We believe this will put pressure on industries and companies that rely on a large, low-paid work-force.
  8. Health-Care Strengthens: Gains in the Health-Care Index have outpaced that in the broader markets by about 10% in 2013. 2014 is the first year the impact of the Affordable Care Act will be felt in revenues of insurers and health-care providers.  We expect health-care revenues will rise and the sector will continue to outperform the broader market this year as well.
  9. Atlantic tug of war: The Euro has appreciated against the Dollar over the course of 2013, as the European fiscal crisis has been pushed off center stage.  We believe the Fed’s tapering will reverse this move and we will begin to see the dollar appreciate as rates rise in the US.
  10. Water Works:  We have been concerned about water-related infrastructure for a number of years. Most population growth is occurring in regions with limited access to large quantities of fresh water and this problem is more acute than any issues with power generation. We believe consumers and regional planners have begun to appreciate this as well and we will see a rise in investments directed towards water infrastructure. Major engineering companies and water utilities should benefit, as will firms with consumer products that improve efficiency.


2013 Themes: Snakes and Ladders – Year End Review

2013 Themes: Snakes and Ladders – Year End Review

At year-end, we review our economic themes for 2013.  We give ourselves 8 out of 10 points, for 7 themes that hit the mark, and two that were partially realized.  We were flat out wrong on one.

  1. üEurope lingers: “…In our view, the European Union will have to provide financial assistance to one or more peripheral countries in 2013, we believe this may be delayed till after the German elections to limit the impact on the Merkel government.”  Cyprus did indeed receive an emergency bailout in 2013. The European crisis continues to be a concern and none of the peripheral European countries have as yet exited the bailout mechanisms put in place.  Spain, Greece, Romania, Cyprus, Portugal and Ireland all received funds in 2013.
  2. ? Asia slowdown: “The biggest Asian economy is showing some growing pains… We believe China will underperform other emerging markets over the next year.” Chinese GDP growth is officially estimated at 7.6% for 2013, markedly lower than the double digit rates it has achieved in prior years.  The Shanghai composite’s total return for 2013 was 3.56%, while the Hang Seng was down 2.84%. Neither are stunning returns, but emerging markets performed poorly as a whole in 2013. The MSCI Emerging Markets index lost 4.9% and Brazil, Turkey and Indonesia all performed worse than China.
  3. ûEquities: “…We believe… there is a strong probability that stocks will be in for a very rough ride… we believe stocks with strong balance sheets, robust business models and high-quality earnings will outperform.”  We were wrong on this call. Though the MSCI World Quality index returned 27.74%, MSCI Europe Quality index returned 21.52% and the S&P High Quality Index returned 32.44%, they were matched by the broader markets. The MSCI World returned 27.37%, the S&P 500 32.39% and MSCI Europe 25.96%.  Lower quality, speculative stocks have led recent market gains fueled by sustained quantitative easing.  Though there was some mid-year volatility, US stock markets saw a sustained rise in 2013.
  4. üThe myth of hyper-inflation: “…the Federal Reserve has bought over two trillion dollars in Treasury and MBS debt over the past four years… When it begins to sell its bond holdings, vast amounts will be taken out of the money supply, putting a damper on any inflation. This is why we find inflation protected bonds relatively unattractive.” TIPS performed poorly in 2013, the Barclays US Treasury TIPS index lost 8.61% for the year. We see virtually no sign of inflation in the US at the moment and do not believe it is a concern for the immediate future.
  5. üA rude awakening for bonds: “The Fed has been providing price support for long-dated bonds with its large purchase program and low interest rates. When that price support stops and the market has to stand on its own, we expect bond prices to collapse and rates to rise… we find long-dated bonds extremely risky and prefer floating rate, short-duration and international bonds.” Long term treasuries were a poor investment in 2013. The Barclays US Treasury 20+ year bond index lost 13.88% as yields on 30 year treasuries rose from 3.04% to 3.96%.
  6. üThe Sun also rises in Japan: “…We see Japan’s demographics stabilizing and a generational change underway in Japanese business creating an entrepreneurial surge. We believe this presents an attractive opportunity for equity investors.” Though most of the market surge occurred in the first quarter, Japanese markets have held on to gains this year and the MSCI Japan index returned 27.16%, the best performance in many years.
  7. üGold: “…We continue to hold that the price of gold is elevated beyond fundamentals and not sustainable. We see demographic changes that are steadily eroding Asian demand for gold, removing this long ranged support. We expect gold prices to drop in 2013.”  We were right here. Gold prices have dropped almost 28% in 2013, from over 1600 to 1170.
  8. ? The death of the PC has been greatly exaggerated: “…Despite being overshadowed by its cooler, touch-sensitive cousins, the traditional computer remains the one device capable of performing the whole range of computing functions. It will remain an essential business tool for years to come. We think it’s a little too early to call the death of the computer, and that certain PC-related stocks will outperform in 2013.” PC sales are estimated to have dropped some 11% in 2013 to around 300 million, with tablet/smart-phone sales surging. That said, in some cases, PC stocks saw enormous gains in 2013 (HPQ 100.33%, MSFT 43.69%, DELL 39.02%, Lenovo 36.1%) even though smart-phones and tablets have continued to encroach on PC functionality.  So while the trend away from PCs continues, 2013 proved that many PC-related companies remain viable businesses.
  9. üNetwork everything: “…Over the course of the next decade, we expect to see more devices linked to the broader Internet for specialized and general function. This will include cars and household appliances, opening up new use cases and opportunities for businesses positioned to produce the right set of products and services. We believe the technology sector in general, and Internet infrastructure firms in particular, offer attractive growth potential over the next decade.” We continue to see upticks in the number of devices connected to the Internet and though it is still early for this prediction, the S&P North American Technology Index return 34.57% in 2013, outpacing the S&P 500 and MSCI World.
  10. üAlternative Energy: “…Alternative energy at utility scale is approaching cost parity with conventional energy generation, and a nascent environmental movement is developing in the emerging world. These two trends are changing the equation for alternative energy and 2013 should see an increase in investment flows towards non-conventional sources of energy. We think prices are relatively depressed and the sector offers attractive value for long-term investors.” Alternative Energy did indeed make a strong comeback in 2013 and more attention is being focused on the industry. The S&P Global Clean Energy Index returned 48.42% for the year and the Nasdaq Clean Edge Green Energy Index returned 89.34%.
Tech and Bonds, the bigger they are the harder they fall: 2013 Q3 letter

Tech and Bonds, the bigger they are the harder they fall: 2013 Q3 letter

Dear Friends,

We hope you had a pleasant summer with family and friends.

The third quarter of 2013 saw global financial markets encounter some turbulence, driven largely by fears of central bank monetary tightening. The Federal Reserve issued a series of statements early in the summer, essentially warning investors the era of large-scale monthly bond purchases and ultra-low interest rates was approaching an end. The wordsmiths at the Fed settled on the word “taper”; we assume in the hopes of conjuring an image of a slow, gentle ride into the QE sunset. Of course, the bond market’s response was anything but gentle as investors began aggressively selling long-dated bonds. Our view for some time now has been that long-dated bonds could see sharp, sudden drops in value if rates begin to rise. The summer was a reminder for bond investors of how suddenly this can happen. On May 1, the 10 year treasury yield stood at 1.66%. By early July, it had risen past 2.66% (a full one percent move) – a level not seen since August 2011, during the summer debt ceiling negotiations. After witnessing the speed at which bond yields spiked, the Fed backtracked on its tapering guidance and yields have dropped a bit. However, we would caution bond investors not to succumb to complacency. There is a high likelihood rates will rise much higher over the next several years. We remain convinced that long-term bonds offer very low prospective returns and recommend short term and floating rate fixed income investments as an alternative.

We won’t spend much time on the budget morass in Congress, except to say we wish there were more responsible adults in the negotiating room. At the time of this writing, Congress is unable to pass a budget which has led to a government shutdown. Meanwhile, an even more critical deadline looms in two weeks, when the US Treasury reaches the debt ceiling set by Congress and is unable to pay for contracted services and perhaps even repay Treasury bondholders on time. This annual cycle of budget brinkmanship has made many bond market participants seriously re-consider the once unthinkable idea that the US may default on debt obligations. Should Congress decide to flirt again with default, we expect a replay of 2011 where stocks sold off and bond yields rose.

Over at the wsqcapital blog, we recently published a piece about how interest rates impact stocks and business enterprises in general. In the post, we listed four ways in which rising interest rates impact stocks:

  1. Investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.
  2. Rising rates make bonds a more attractive investment alternative for investors.
  3. Rising rates also mean higher borrowing costs for companies forcing them to reduce investment expenditure to meet increased financing costs on existing debt.
  4. Businesses and governments use higher interest rates to evaluate future projects; marginal projects or investments are shelved if they are no longer viable due to higher borrowing costs, slowing activity.

All these factors in tandem weigh on stock prices and are reasons for stock investors to be cautious when interest rate increases appear likely. The current low interest rate environment and monetary easing has pushed up stock valuations and we believe there is limited upside for investors when the market is already trading at 17 times earnings, well above the historic average of 14. That said, we continue to see pockets of value within certain sectors that have fallen out of favor with investors.

The past few months have also provided a few stark reminders of the speed at which technological changes can impact companies previously considered unassailable. A list of former blue-chip tech stocks that have fallen on lean times include: HP and Dell. Furious competition from Asian manufacturers and low levels of product differentiation have decimated PC makers. The rise and fall of these companies seems positively glacial though, when compared with the fate of firms producing cellphones and mobile technology in general. Palm, Motorola, Nokia, and even Blackberry have found their once-enviable businesses hollowed out as touch-screen driven smartphones were created and then adopted with fervor by consumers and businesses.

In some ways, the mobile phone sector has made the same transition Internet companies did a few years earlier. Early internet usage revolved around e-mail and very simple forms of media. As bandwidth and processing power improved, usage migrated to much richer media including video. This trend continues as film and TV distribution steadily migrates to the Internet. Mobile phones followed a very similar trajectory. The first internet connected phones offered very simple and limited functionality. As data capacity improved, Blackberry was able to create a compelling product by offering reliable e-mail service on your phone. Palm meanwhile continued to be the gold standard in mobile organizers with its pilot line of digital assistants. Touch-screen enabled smartphones starting with the iPhone pushed aside all other devices by offering a single package that was capable of taking pictures, making calls, receiving e-mail and providing a more vibrant mobile Internet experience than ever before. A rich internet experience on a device that fits in your pocket became the must-have application for a younger generation accustomed to constant connectivity.

In retrospect, it all seems rather obvious. However, it would have been difficult to predict, on the eve of the iPhone’s debut, that one of the biggest winners in mobile technology would be Apple. There was little to suggest then that the former PC maker, which had almost gone under a few years prior, would emerge with the winning solution. It would have been tougher still to see that Apple’s primary competitor would be an open software platform offered by a competitor with limited interest in making devices and a business strategy that revolved almost entirely around offering services and search on smartphones. Yet, Google has marched ahead of Apple in terms of platform penetration with its Android product. We have a better handle on technology than most, but we continue to caution investors that the pace of change in the business of technology is frantic. Business models that looked bulletproof only a couple of years ago, now lie in tatters. To be an effective investor in the technology sector requires constant vigilance.

We continue to advise investors to keep their portfolios oriented towards long-term goals and exercise some caution, by maintaining judicious limits on their holdings of long-term bonds and speculative stock. Both the interest rate and equity cycles suggest lower future returns from risky assets.


Louis Berger                                                                                        Subir Grewal

Interest Rates and Stocks: comparing numerators and denominators

Interest Rates and Stocks: comparing numerators and denominators

For the past couple of years, we have been highlighting to our clients the fact that the market value of their bond portfolios will drop when rates rise. This is especially true of long-bonds.

However, we haven’t often explictly discussed the impact this can have on stocks. All else being equal, rising interest rates exert downward pressure on stock prices. There are four reasons for this:

Institutional investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.

In standard financial analysis, a stock is modeled as a very long bond (a perpetual) with uncertain interest payments (dividends or earnings). If we do this, the dividends are estimated as an annual or quarterly stream, and this is discounted back to today using the appropriate discount rate. As you can imagine, when the discount rate rises, this raises the denominator of the fraction and the current value of a fixed dividend stream falls.

Borrowing costs for companies rise, which means more revenue is diverted to satisfy financing requirements.

Any firm with variable rate debt or a need to roll over debt will encounter a higher cost of funding, and if all else stays the same, these higher payments eat into income available to shareholders. In the dividend discount model we described above, this reduces the value of the numerators, which of course leads to a fall in the current value of the dividend stream.

Higher rates also result in lower economic activity as  households and businesses find a larger percentage of their wallet share going to fund interest payments.

Businesses evaluating future projects use higher rates to review their attractiveness; marginal projects or investments are shelved since they are no longer profitable, reducing earnings growth.

At the same time, rising interest rates change the calculus for future projects and investment. A company building a new factory or launching a new product will analyse the future earnings and weigh them against current costs. Projects that look good when borrowing costs or rates are at 4%, may not be economically feasible at 6%.  Apart from financials, real-estate is the sector most sensitive to rates, but so is any heavy industry with significant capital costs.

Rising rates make bonds more a more attractive investment alternative for investors.

This is perhaps the simplest and most under-appreciated reason that higher interest rates lead to lower stock prices. As investors evaluate various investments, rising rates make bonds appear more attractive.

The counter-argument to these is that rising rates in our modern central bank led monetary regime imply broad confidence in the economy. We accept that this is broadly true, but will leave it till a later date to review the historical record.

Yelp, I’m drowning in the medium

Yelp, I’m drowning in the medium

A story about the founding of Yelp led us to wonder why Zagat didn’t create Yelp. The core idea (reviews by consumers) is exactly identical, and the Zagats had their brainstorm in 1979. Why couldn’t they translate the phenomenal success of their printed reviews and their formidable brand into an online presence with a moat that would deter everyone else?

Of course, Zagat does have a website, and you can even get and write reviews on it. But to use it, you have to sign up for a subscription. That is the relentlessly logical solution from their perspective. After all, why would Zagat cannibalize the valuable revenue stream they drive from selling their slim brown books by making the reviews and ratings available online for free? Yet, this perfectly reasonable decision made them an also-ran on the Internet, ultimately fit for a purchase by Google to bootstrap their location review content. If Google hadn’t bought Zagat, the end would have been even more ignominious.  As most reviewers would have migrated to online sites, Zagat would have died a long, comfortable death as it’s core subscriber base aged into a comfortable retirement.

There is a lot that can be said about this, one of the more obvious things is that most companies are reflections of their founders.  The broader truth though is what Marshall McLuhan outlined in Understanding Media, or in the soundbite, The Medium is the Message. The new medium of the Internet has transformed not only message delivery and message representation, but the message itself, and us as well. Any entity that fails to adapt to the new medium is relegated to the archives. It has even changed human and societal behavior and will continue to do so, inexorably. This is as true for restaurant reviews as it is for books. And thanks to ipads, as true for your parents as it is for toddlers.

The medium of the Internet has its own relentless logic, content has to be speedily delivered, ideally at no cost, look fresh, be current, as comprehensive as the world, and appeal to very exacting, specific tastes. Oh, and you have to make the audience feel they have a voice, either through forums or direct interaction. Absent these features, you’re paddling against a powerful tide. Zagat misunderstood one feature of the Internet and that left enough of a crack open for Yelp to eat their lunch, and dinner.

Tale of two economies

Tale of two economies

“There’s only four things [America does] better than anyone else: music, movies, microcode (software), and high-speed pizza delivery.” — Neal Stephenson, Snow Crash.

There are increasingly, two different economies in the country, the knowledge economy, and the physical economy. The knowledge economy is thriving, since that is most of what we export nowadays and much of our lives are lived online. However, technology employs only part of the American workforce, and everyone working in the physical economy (construction, building, materials) is hurting. People who had been furloughed from the plant in prior recessions, only to come back to work when conditions improved five months later, are now facing the prospect of long-term unemployment.  How the US recovers from this particular recession will depend on how well this transition is managed.

We wrote the paragraph above in October 2009, almost four years ago.  The labor force participation numbers from September make it seem prescient. Rosie the iconic riveter did lose her job and never got another. The Bureau of Labor and Statistics tracks labor force participation (those working or seeking work), and this has dropped from 66.4% in January 2006 to 63.2% in August 2013. Some of that drop represents baby boomers retiring or retiring early, but that does not explain the entire 7 million people who are no longer working or looking for work. Some of them are discouraged from years of disappointment. The toll in lost opportunity and human skill for the economy represents a permanent loss. These years, for those workers, cannot be reclaimed.

That Internet in your pocket is disrupting the world.

That Internet in your pocket is disrupting the world.

 400px-Mobile_phone_evolutionWe don’t often write about individual companies on our blog since we feel all investments need to be considered in the context of a portfolio and an investor’s objectives. We will be making an exception here, since we’re gong to discuss the evolution of an industry where the pace of creative destruction has been frantic, and it’s futile to write about these trends without mentioning the companies and products that embody them.

The FT published a letter one of us wrote about how open-source development has impacted smartphone evolution. Open-source tools and systems are the foundations for the current generation of mobile devices. The two dominant operating systems for smartphones, Google’s Android and Apple’s iOS have open-source roots. Most people will recognize that Android is a Linux build, but iOS which is a Darwin variant, and therefore a direct descendant of BSD (early open-source Unix). That Apple does not license iOS is largely irrelevant, an engineer who has worked on Unix systems will find iOS a warm, fuzzy, familiar environment.  As long as Apple and Google don’t stray too far from this well-understood environment, future generations of internet engineers will find few barriers to developing for its devices and systems.

It’s not just about operating systems though.  Companies that build commodity, widespread platforms, whether software or hardware have come to realize that openness is a virtue, and often a necessity. Their platforms are tool-benches which are only as useful as the tools or applications that external developers create for them. Integrated Development Environments and core development tools for internet-enabled applications tend to be relatively open and community maintained as well. The list is extensive, but includes Linux, Apache, Eclipse, MySQL, Python and other tools that are part of the essential plumbing and growth of the Internet.  Virtually every Internet startup we know of begins  life with a Linux installation running Apache, often a cost-effective virtual machine at Amazon’s AWS or countless other providers.

What Apple unleashed with the iPhone wasn’t only a device that appealed to consumers and looked beautiful; of more significance to its future trajectory was that the development platform is similar to Mac OS-X, so large numbers of developers could quickly learn to write applications for the device. Where prior generations of phone app developers struggled to understand a carrier and phone-maker’s system, with an occasionally tweak to low level network infrastructure like WAP, iPhone developers were on familiar ground, within an environment that looked pretty much like a trimmed down OS-X, and with similar development tools. This is what made the explosion of apps on the iPhone so rapid.  Android has been able to compete only because it’s largely Linux and apps for it are written in Java, both of which are even more widely adopted and used amongst Internet developers.

Microsoft is only in the running because someone at the company had the good sense to kill Windows CE and commit to a common platform for desktops and mobile devices, combining the development communities. Perhaps surprisingly for the platform providers, content is king, and that is where they need to differentiate themselves. Traditional media (music, tv, movies) is owned by traditional interests and will generally seek to be platform agnostic and available everywhere. The differentiating factor is new media created by a younger creator and applications created by enthusiastic communities of developers. Nurturing these and adapting to their needs will be the path to success for the platforms. As an aside, if you agree that smartphones are computing devices, since smartphone shipments overtook PC/Laptop shipments last year, it’s only a matter of time before the most widely installed operating system on the world’s computing devices is no longer windows but some Unix variant.

Meanwhile, within the space of a few years, stalwarts of the early phase of consumer mobile telephony and computing have had near-death experiences or been devoured by firms they would not have considered competitors a few years prior. Motorola, Palm, Ericsson, Qualcomm and now Nokia fell on their swords or came perilously close to doing so.  Blackberry, which seemed unassailable even four years ago is facing an existential crisis.  Revenue streams and margins that seemed robust were eroded with frightening speed.

We wonder of course, about what happens next in this industry.  The first lesson for investors is that the product cycle in mobile technology is immensely quick and margins compress with dizzying speed. In our view, no company in the mobile computing world has a business model that we say with confidence will support strong or even positive margins seven years out.

What we do know is that hardware is quickly becoming less of a differentiating factor.  Most current smartphones have roughly equivalent hardware.  Nokia might have a slightly better camera, Apple may have a better display, and HTC may have the best low-light camera around, but that is not enough to make a difference. Most consumers will not notice the difference. And that means smartphone hardware makers are going to find the next few years tough going.

The platform vendors, Apple, Google, perhaps Amazon and with some luck Microsoft, are better positioned. They should be able to retain income from media purchases on their storefronts (iTunes, Google Play, Amazon Kindle) and can continue to develop additional streams of subscription-like income. The ubiquity of mobile phones with rich data ability should mean strong revenues for mobile network equipment makers and services since infrastructure worldwide will need to go through a few upgrade cycles over the next decade (and Nokia may well find a second life as a business in that space).

We need to look elsewhere though for the next generation of disruptive business models enabled by the Internet in our Pockets. Fast and cheap connectivity paired with ever more capable devices is quickly turning every waking moment into an interaction between online and offline inputs. We now see the  value we believe now shifts to content providers, creators and geo-location based services, this is where we expect to see the next generation of stand-out businesses emerge. GPS mapping software was in some ways the beginning and location-aware advertising is already here.  In many places, Yelp is becoming the go to source for recommendations. Foursquare could arguably have an even more powerful business model if it could manage to convert itself into a effective loyalty program or customer relationship management application for small and large businesses, but first it needs to get past badge fatigue. Uber and its ilk will transform the taxi industry in most large cities. A new generation comes of age every year that is far more comfortable living life on its phone. They will steadily move their wallets to their phones (Google Wallet, Paypal) just as they have their social interaction (Facebook bought itself a couple of lives by purchasing Instagram). Companies that figure out how to curate useful content and tools for smartphones should prosper (Twitter, Evernote, Dropbox, Pandora, Spotify, Flipboard). Yahoo, if it plays its cards right, may be able to capitalize on Flickr and Tumblr to rejuvenate itself.  They may also want to revisit their roots since curated content will be part of the future of mobile computing. The broader message is that content is king, and content created by an enthusiastic community of creators is what’s needed to build and maintain an engaged audience.

This meld of the physical and virtual worlds has been a long time coming. Regular readers may remember our post on Facebook, Cypherpunk and Psychohistory which referred to Neal Stephenson’s prescient novel Snowcrash. Augmented reality is coming soon, which is why we do not scoff at Google Glass or other wearable computing devices like smart-watches. We will see ever more portable interfaces into the virtual world, and there will be applications for many of them.

It’s not just Middle-Eastern dictators who have learned to respect the power of the computer in your pocket, so will less political entities whose lifestyle and business models rely on things staying the same.

Efficient Markets, Mean Reversion and why chickens come home to roost

Efficient Markets, Mean Reversion and why chickens come home to roost

450px-Zoo_chicken_roostingA recent article in the Financial times, Clash of the CAPE Crusaders, on the radically different conclusions arrived at by Jeremy Seigel and Robert Shiller when evaluating long-range stock results reminded us of an draft post we had begun a while ago.  This debate between value investors and others has been running for a long time, the latest iteration goes something like this:

EMH camp: Since we know stocks over time out-perform other investments and do not know what stock prices will do tomorrow, it is OK to go ahead and invest in stocks, and you should invest in a broad list of stocks (say an index fund).

Value camp: You should only invest in specific stocks when you have done your analysis, and believe the return from the investment will compensate you for the risk you are taking.

EMH camp: You don’t know what the price of the stock will be tomorrow, so there’s no reason for you to choose to invest today.

Value camp: That is true, but we don’t care about tomorrow, we care about the likelihood of prices being higher 3, 5 or 7 years from now, and that will depend on whether we are buying bargains now, since over time the true value will be reflected in the price. And even if it isn’t reflected in the price, our analysis has given us confidence that this is a good business proposition and the downside is limited. I can show you numerous periods where a purchase of stocks would have resulted in huge losses within relatively short order, and this is generally because prices exceeded value.

EMH camp: But you would have said they were overvalued well before they started to fall, and I would have lost out on some gain, and I know that over the long-term, stocks will do well.

Value camp: True, I admit that I cannot predict when exactly a bubble will end, but I do know when one is underway, and that it will end eventually. I’d rather make a little less, than risk losing a lot.

EMH proponents have always seemed to us like naughty children who hurt themselves periodically while swinging from trees and then blame their parents for not watching out for them. The oft-expressed view that the market always values all investments correctly seems to us a convenient tautology. There are numerous instances of speculative manias running amok, and they generally concern some new technology or market. Wildly optimistic rates of growth are assumed and incorporated into “analysis” by herds of professional investors, while non-professionals rush along in tow.  These speculative mania always end, and with remarkable speed.  We call EMH a tautology since most adherents would say this is perfectly acceptable and a result of new information being incorporated into the marketplace.  Our sympathies lie with the mean-reversion camp and their view that markets periodically overshoot highs and lows, creating opportunities for investors who can anticipate the eventual return to the norm.

We view our role as value-oriented investment advisors to find and understand these under-appreciated pieces of information, to evaluate their impact on investments and position ourselves to take advantage of them.  In Gretsky’s over-used metaphor, we skate to where the puck is going to be.  There are, however, limits to our powers of anticipation. Mean-reversion can take a long-time, and our investors generally have a limited time horizon. This is why, in our role as prudential advisers we generally maintain some investment in stocks in our balanced portfolios. At the same time, we realize that mis-pricings and mean-reversion applies to all asset classes and markets, though the impact may be more extreme in stock markets.  So, for instance, we have been very careful about the types of bonds we have purchased and held for clients over the past few years. We know interest rates cannot be kept at zero forever, and this means long-term bonds offer limited upside and a lot of potential downside. For the past couple of years, we’ve kept bond duration in most client portfolios at very low levels since we have not seen value in long-term bonds.

Commodity supercycles, Windup Girls and Family Farms

Commodity supercycles, Windup Girls and Family Farms

In our SRI portfolios, we screen companies and industries for those actors who run sustainable businesses. Their usage of resources and fulfillment of broader responsibility counts as much as their financial prospects.  Ocassionally, we step back from our narrow interests in a specific company or industry to look at the broader picture.

We did that recently while reviewing the latest quarterly letter from Jeremy Grantham at GMO. In a note last year, Grantham had highlighted the impact that intensive conventional farming practices can have on the quality of soil. Healthy soil takes many, many decades to develop and the intensive use of pesticides and fertilizers can destroy microbial life in topsoil. Once that happens, it requires a continual regimen of fertilizers to make the land productive.  Intensive commercial farming techniques have killed life in the top soil, and this will have a long-term impact.

Those who’ve read Michael Pollan’s Omnivore’s Dilemma might remember the section on Polyface Farms. Pollan describes Salatin’s effort to rescue a ravaged industrially farmed tract using a complex crop and animal rotation regimen. It requires prodigious  knowledge of the local environment and intellectual rigor on the part of the farmer. The level of effort is a couple of magnitudes greater than that required to flood a field with fertilizers, pesticides and irrigation.

If intensive, fertilizer based farming permanently damages our agricultural production, this will have long-range impact for us. What does the steady depletion of our ability to produce food mean for the economy and our race? The first impact will be felt by the world’s poor, who will be priced out of food. This would lead to a rush to accumulate scarce resources and political unrest, possibly more revolutions like those we are seeing in the middle east.  Since the industrial revolution, the effort we have expended to raise crops and feed ourselves has steadily declined.  In the mid-1800s, fully three-quarters of all American workers lived and labored on farms, that number is under 3% today.  The story of progress in the 20th century has to a large extent been driven by the unshackling of vast numbers from the plough. A world where more human effort is required to raise the same amount of food would be one with lower growth, fewer advances and less comfort.

While, we’ve been thinking about these big trends, we’ve been following the Olympics, and the incessant ads reminding us that “luck” had no role to play in the success of any athlete. The truth, however, is that luck plays a large role. Most of the successful olympic athletes were lucky to be born into families or in nations where they were assured a consistently high caloric intake, access to a top-notch training program, and institutional support from their countries and employers. Meanwhile, many, many people in poorer parts of the world will never have that opportunity. The lottery of birth is truly amazing.

Life occasionally imitates art. For a dystopian vision of where intensive commercial farming and climate change might lead us we would recommend reading The Windup Girl, Paolo Bacigalupi’s richly imagined novel about a world ravaged by climate change, genetic modification and crop failures. Robert Heinlein’s book, The Moon is a Harsh Mistress tackles similar topics, from the standpoint of a colony on the moon. Of course, our salvation may lie in the exploration of our solar system, which is rich in resources. But the space program has been as underfunded as investment in training farmers to use organic practices.


2013 Q2 letter: Tapering off the rocket-fuel

2013 Q2 letter: Tapering off the rocket-fuel

 We hope you are enjoying the summer thus far.

In the financial markets, things seem to be heating up as temperatures rise across the northern hemisphere. The events of the last few weeks of June seem to have triggered a wake-up call for many investors who may have been lulled into a false sense of security by a market that rose steadily throughout the winter. Many long term trends are starting to reverse course and risks we have been tracking for several quarters are beginning to materialize.

Space Shuttle lift-offIn a large part, the moves are being driven by two major players: the central banks of the US and China. In the US, various Fed board members have been travelling the country recently in an effort to warn investors that the enormous amount of bond purchases being undertaken monthly by the Fed will begin to “taper” off. In many ways, it is an attempt by the Fed to let all the party-goers know that the punch-bowl is about to be taken away. They aren’t saying it’s midnight and the party is over, but they have made it clear they are watching asset bubbles, have taken into account the improvement in housing and employment, and will be moving away from crisis tools. In other words, it’s Last Call.

The market has been discounting the probability of this happening for some time, but these recent public pronouncements have forced a rapid adjustment of expectations. The 10 year treasury rate has moved about 1% in a couple of months, wreaking havoc in any leveraged rate portfolio. The last time rates moved this rapidly was about 20 years ago. While this may be the beginning of a larger move that we believe will be spread over many months, the larger picture should be clear: the 30 year bull market in bonds is over. Bond investors should be prepared for potentially a five to six year period of rising yields and falling prices.

Meanwhile, on the other side of the world, China has executed a rather smooth transition of power, but the cost in terms of economic imbalances has been large. Like the US, the Chinese authorities have maintained an easy money policy since the onset of the global credit crisis. Along with looser credit, they have delivered large fiscal stimulus, by spending on investments, largely on infrastructure and other construction activity. Much of this spending has been financed with credit, and the borrowers are primarily local municipalities and governments. In many cases, projects are initiated and built to satisfy bureaucratic ambition, rather than commercial ends. Many of these projects will be unable to recoup their costs. In some ways, the outlook for Chinese regional governments is worse than it ever was for US municipal debt. The central Chinese authorities have begun to rein in excessive credit growth after voicing concerns over rising levels of indebtedness in late 2012 and early 2013. Overnight lending rates were raised unexpectedly in June, and this shocked Chinese banks and lenders. The local stock market promptly fell over 20%. We expect the re-adjustment in China to generate more pain for investors, and this will impact resource driven economies like Australia and Canada  who have been relatively immune to the malaise in the US and Europe, In our view, these recent monetary policy adjustments by the US and China will most adversely impact the future prospects of multinational banks. Banks that have positioned themselves for the move will benefit as the Fed withdraws from purchasing long-dated bonds. As the yield-curve steepens (long-term rates rise faster than short-period rates), the core lending franchise of most banks should become more profitable. While long-term rates rise faster than short-term rates, banks will profit since they generally borrow or take on deposits paying short-term rates and receive long-term rates on loans made. The problem is that in the aftermath of the financial crisis banks shrank the volume of general lending they were doing and began to load up on long-dated bonds of government and quasi-government entities instead in their search of low-risk investments. As rates rise, these bonds will drop in value, leading to painful losses which impact balance sheets and bank income statements. We see few banks/financials that have adequately prepared for the inevitable rise in interest rates, and we believe most financials will underperform over the next two years.

Another noticeable theme this year has been a steady profit-taking in various speculative momentum assets that have enjoyed outsized gains over the past few years. From Apple and Emerging Market stocks, to Gold ETFs, high-dividend stocks and High Yield Bonds, the speculative investments of choice have sold off over the past few months with breakneck speed. To us, this signals a loss of confidence in the late stages of a rally and is not a positive sign for equities (neither are rising interest rates). That said, the dramatic drops in certain stocks have created select opportunities for value investors like ourselves.

We have been re-positioning client portfolios to take advantage of some of these long anticipated moves. Most client bond portfolios have been heavily weighted towards short-term, low duration, and floating rate bonds and funds. We have continued this positioning and have attempted to reduce long term bond exposure. For more tactical portfolios, we have added a short-position on long-dated bonds (an investment which gains from drops in the value of long-dated bonds). We believe this leaves us well placed to take advantage of a rising yield environment. Where appropriate, we have been adding stock to client portfolios, generally high-quality, income-generating issues (rising dividends). We also added Japan exposure to many client portfolios late last year and very early this year. We think selected Japanese equities are a good, long-term holding and there is another opportunity to acquire them after the recent sell-off.

We have also been adding alternative energy exposure to client portfolios where appropriate. Alternative energy stocks sold off dramatically as the solar sector went through growing pains over the past few years. We believe the adjustments in the sector brought on by large-scale Chinese capacity build-out and the expiration of certain tax credits are largely complete and the industry is now poised for growth and value creation.

We expect markets to continue to be volatile this summer, and we aim to stay in touch with all clients, please feel free to call us if you have any questions.



Louis Berger                                                                                        Subir Grewal

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

2013 Q1 Letter: Spanish Mortgages, Cypriot Banks & Earth Day

We hope 2013 has gotten off to a good start for you.

We want to start off by wishing you a Happy Earth Day! We exhibited at the Green Festival in NYC over the weekend, and it was great to see so many friends there, and to make some new ones. We are always pleasantly surprised by the number of people who are eager to learn more about Socially Responsible Investing and how their portfolio can do good as it grows.

The first quarter of 2013 saw risk assets continue to rally. Despite continued concerns about the state of continental Europe, major US stock indices reached fresh all-time highs in March, six years after they last reached such elevated levels. The effects of inflation and dividends that have accrued to investors effectively cancel each other out, and so it is rather impressive that six years after the first warning signs of the impending credit crisis appeared, investors have regained most of the lost ground. Of course, the constitution of the indices have changed, many enterprises that were mainstays of the Dow and S&P have been expelled from them and new upstarts have taken their place. That, however, is the creative destruction of the market at work.

CyprusIn Europe, a low-grade fire continues to smolder and it seems as if the news continues to get gloomier. March brought news that overall unemployment in the Euro-zone reached 11%, a level not seen for over 50 years. Investors should not be sanguine; the economic crisis in Europe is severe and will take many years to recede. The roots of Europe’s problems lie in the excess of development, spending and borrowing that occurred in the Medittereanean states, most of it funded by loans from the North. It has been illuminating to see the difference in responses between crisis-stricken Northern European countries and those in the South, which appear to have played out like a parody of Max Weber.

The first casualties of the crisis were Iceland and Latvia. Both are small countries with financial sectors that had recently ballooned. Another was Ireland. In each instance, the general population seemed almost resigned to the effects of the bubble bursting. It was almost as if, as per the caricature, Northern Europeans were used to misfortune and hardship, taking it in stride. Draconian measures were taken in all three countries. Banks were liquidated, along with real-estate developers and many ordinary businesses caught in the indiscriminate downturn. Meanwhile, families adapted quickly to a far less comfortable lifestyle, embracing austerity with an almost welcome sense of Lutheran penance.

Meanwhile, similarly crisis-stricken countries in the South (Greece, Spain, Italy and now Cyprus) have seen wide-spread unrest as their citizenry have resisted austerity measures every step of the way. We empathize immensely with the ordinary people caught in economic events that are not of their making. In many cases, individuals with limited financial experience just happened to have made poorly timed decisions, with no understanding that there are good and bad times to extend oneself by taking on debt. For the past three years, Eurozone nations have been haggling over how to apportion the blame and cost of the cleanup.

This quarter saw two diverging answers appear. The first is from Spain and was not widely covered though it has far-reaching implications. The second is from Cyprus and was widely covered by the media due to its dramatic nature.

Spanish mortgages are very different from American mortgages in one key respect: a mortgage in Spain is both a secured debt and a personally guaranteed, recourse loan. Lenders can repossess the property securing the loan, and continue to pursue the borrower for any shortfall or costs resulting from the repossession, till the entire debt is repaid. A Spaniard who has his house repossessed and sold by the bank will continue to owe the bank any shortfall between the sale price and the amount of the mortgage. Personal bankruptcy is not an option for most, so it is almost impossible to start with a clean slate.

Many Spaniards discovered the nature of their mortgage debt after the crisis, and after home prices were halved. Thousands of ordinary Spaniards have been evicted from homes they owned due to delays in mortgage payments and subsequently find themselves owing the bank tens or hundreds of thousands of Euros since the property does not cover the entire debt. Scores of former homeowners have been driven to suicide to escape crushing debts. Meanwhile, unemployment in Spain hovers around 25%. These are truly depression-era conditions, and they have seen wide-scale protests similar to the depression.

Amidst all this turmoil, The European Court of Justice heard a case brought by an evicted home-owner, Mohammed Aziz, and decided the original terms of the mortgage agreement were unfair. Spanish courts can now overturn evictions and repossessions on the grounds of consumer protection.

Meanwhile in Cyprus, an event almost as remarkable was briefly averted. For a few days, it looked like deposit insurance was about to be over-ridden for all Cyprus bank customers. The largest Cyprus banks found themselves facing large losses on recent purchases of Greek sovereign debt. As part of a deal to provide rescue funds for them, Northern European finance ministries insisted that depositors bear some share of the burden. Late one Sunday, a plan was announced to levy a 5-7% charge against small depositors and a much larger one against those with deposits larger than 100,000 Euros. As one might expect, this led to pandemonium in the streets and in the Cyprus parliament.

In one way, this episode was a good reminder for us all that deposit guarantees are only as good as the political will that stands behind them. In the case of Cyprus, its Eurozone partners were politically unwilling to rescue the banking system of an offshore financial center widely reviled in the tabloids as a conduit for tax-evasion. Sweden’s politicians did not find it palatable to make whole Russian businessmen. We do agree that large depositors should face some losses during major bank failures. In recent years, many have forgotten that their deposits are liabilities of the banks and only as sound as the institution’s health. Indiscriminate bank rescues perpetuate moral hazard. That said, we believe it was a grave mistake even to suggest that smaller depositors would no longer enjoy full deposit coverage for their accounts. It doesn’t matter whether the levy is called a wealth tax or a deposit charge, imposing losses on small depositors weakens the banking system for everyone. What’s even more embarrassing than the sight of finance ministers making mistakes that Bagehot warned against 150 years ago is that the moment the plan saw clear light of day and they heard the uproar, all the decisions were reversed. So, the EU members have managed to look weak and incompetent while scaring small depositors and instigating a full-fledged bank run within the Eurozone.

So what does this mean for investors in the short and long-term? We believe the European crisis has yet to reach it’s denouement. We live in a interconnected world, and despite record profits for US corporations, any rapid deterioration in Europe or Asia could impact US stocks very quickly. We believe investors will be well-served to exercise caution in equities markets and consider taking profits selectively. Meanwhile, bond investors have to reconcile two competing concerns: any eventual removal of quantitative easing will hurt bond prices, especially since we are seeing record low yields and record highs for bonds. That said, a recession or crisis in Asia or Europe would lead to a flight to quality and likely support US bonds of all types.



Louis Berger                                                                          Subir Grewal

2012 Q4 Letter

2012 Q4 Letter

Dear Clients & Friends,

As the New Year begins, we’d like to wish you and your family a wonderful 2013.

2012 was quite an eventful year for the global economy. The Federal Reserve maintained exceptionally low rates, which prompted a number of reactions from investors and consumers alike. Home mortgage rates remained near historic lows, boosting the number of homes sold. That said, much of country still carries excess inventory and new home construction is a mere shadow of its 2006 peak. Household formation – the biggest driver of housing demand – remains low as unemployment in much of the country is still at recessionary levels.

The employment picture improved over 2012, with new unemployment claims down to 350,000 per week in December, a level consistent with moderate growth. However, a substantial number of workers remain unemployed or under-employed and many have been out of work for an extended period of time, making workforce reintegration more challenging. On a positive note, various factors are prompting resurgence in US manufacturing. Concerns about intellectual property theft, rising energy costs, the brittle nature of global supply chains, and higher labor costs in Asia have combined to force many industries to consider opening factories in the US. Employment expectations will have to be tempered as any new manufacturing facilities in the developed world shall be highly automated and employ far fewer workers than older facilities. In addition, workers will require higher level training as new factories will be more complex than past assembly lines.

Despite strong headwinds, most equity markets globally enjoyed double-digit returns in 2012.  The S&P 500 rose 13.4% on the year, and when dividends are factored in, the total return was 16%. Some foreign markets have done even better, despite relatively uneven news over the course of the year.

The US economy has seen 4 years of unbroken growth since Q1 2009. This makes the expansion comparatively long in the tooth since the average post-war expansion has lasted only 14 quarters. 2013 will pose a series of difficult questions for markets, many of them political in nature. The stalemate surrounding the 2001/2002 tax cuts has been resolved with rates staying level for all except the highest earners. However, a number of confrontations between Congress and the President over the debt ceiling, defense spending and troop withdrawals loom in the coming months. The US continues to run a deficit and by February, the Treasury will be unable to meet its monthly expenditure unless Congress raises the debt ceiling. The market is increasingly losing confidence in Congress’s ability to put aside ideology and act in the national interest. The wide ideological divide between very active right wing elements in the Republican party, and center-left elements in the Democratic party who believe not much was gained from compromise during the first Obama administration, guarantees the next couple of years will make for continuing political drama. To a large degree, this situation is an outcome of the US election in 2012. The election was expected to be a referendum on the Obama administration’s policies and a clear majority of voters opted to have the president continue to implement his policies.

Over in Europe, a similar dynamic is playing out. The political establishment is in stalemate while the broader European economy struggles towards a recovery. The French election this year has led to a Socialist far-left government of Francois Hollande possibly over-reaching by raising income tax rates to staggeringly high levels (over 75%) and inserting itself rather visibly into disputes with industry. Southern Europe continues to flounder, with Mario Morsi resigning as prime minister in Italy. Spain and Greece continue to be racked with widespread protests over austerity measures. Portugal and Ireland, meanwhile, seem to resigned to draconian austerity with characteristic acceptance of hardship. Perhaps most troubling of all is the suggestion amongst some circles that the United Kingdom may opt to withdraw from the political union while trying to maintain certain trading privileges. We do not expect any resolution to the European crisis till after the German elections in 2013.

In Asia, the Chinese economy continues to sputter, new car sales have dropped, along with energy demand and home prices in most cities. The politburo standing committee transition occurred in November after the US elections with an apparent loss for the Jiang Zemin faction that was closely associated with party elites. Meanwhile in India, it appears the Congress government faces a very difficult legislative session as the economy slows, inflation picks up and various necessary reforms are held up. The one bright spot in the East, surprisingly, is Japan. Japanese voters handed the LDP a resounding victory in the recent elections. The newly (re)elected government of Shinzo Abe seems to intend to use its super-majority to the fullest extent. It has been surprisingly assertive in demanding the Japanese Central Bank set an inflation target of 2%. The broader market has turned positive on Japan, perhaps relieved to finally see political will in action. We remain wary of investments in China, are more positive on India and relatively bullish on Japan.

In the final analysis, for much of the world, we return to the question of sovereign and household debt. This question is particularly acute for Japan, where total government debt is now over 200% of GDP. Meanwhile, in the US, consumers continue to pay down debt, deleveraging to a more sustainable level while the federal government will likely run deficits for another 2-3 years to compensate. We are now five years past the crisis of 2007, which was caused by a vast bubble in debt and spending. These cycles typically take seven years to resolve and we expect the current dynamic of restrained growth to continue for another two to three years, with significant risk of another recession in the near-term.

In terms of our 2013 investment outlook, we see a number of risks and opportunities. We believe bonds, particularly 20-30 year treasuries are ripe for a correction. Long-term bonds are priced for perfection and will face a severe sell-off when the market suspects the Fed is about to raise interest rates or end its QE program. This could present an opportunity for investors to increase medium-term bond holdings (3-5 years) and longer-dated bonds over time. We see value in international and emerging market equities and would look to add to positions over the course of the year. Portions of the US equity markets potentially look quite attractive if there is a significant correction (we believe a number of political and economic factors could trigger this). We think alternative energy and network-driven businesses would present a particularly interesting buying opportunity during a correction. These and other topics are explored in more detail in our Top Ten Themes for 2013.


Louis Berger   Subir Grewal

2013: Top Ten Investment Themes

2013: Top Ten Investment Themes

2013 Themes: Snakes and Ladders


  1. Europe lingers: The full-blown European crisis has been with us now for almost 4 years. It appears to morph into a different shape every few months. We believe political action and inaction in Europe will continue to drive global markets this year. Two important events will occur in 2013, a German election, and possibly a referendum in the UK on its relationship with Europe. In our view, the European Union will have to provide financial assistance to one or more peripheral countries in 2013, we believe this may be delayed till after the German elections to limit the impact on the Merkel government.
  2. Asia slowdown: The biggest Asian economy is showing some growing pains. 2013 may be the year when China backs away from a policy of growth at any cost and its institutions embrace a more holistic view of economic advance that includes environmental regulation and some liberalization of speech and rights. Though in the short term this might well lead to upheaval and a growth-shock, in the longer term, it will strengthen Chinese consumption. We believe China will underperform other emerging markets over the next year.
  3. Equities: Global Stocks are almost four years into an expansion that began in March 2009. On average, since the great depression, stocks have risen for just under four years before seeing a correction.  We have been skeptical of economic growth driven by monetary stimulus virtually since the beginning, and our view has not changed. We believe the prolonged monetary stimulus has built up imbalances in the system and as policy-makers remove the stimulus, there is a strong probability that stocks will be in for a very rough ride. Many companies have learned a lesson from the credit crisis and we believe stocks with strong balance sheets, robust business models and high-quality earnings will outperform.
  4. The myth of hyper-inflation: Certain observers have been trumpeting the risk of high inflation as a result of Fed easing. We do not believe this is a likely scenario. Whilst implementing staggering amounts of quantitative easing, the Federal Reserve has bought over two trillion dollars in Treasury and MBS debt over the past four years. This huge balance sheet gives the Fed an enormous arsenal to combat inflation. When it begins to sell its bond holdings, vast amounts will be taken out of the money supply, putting a damper on any inflation. This is why we find inflation protected bonds relatively unattractive.
  5. A rude awakening for bonds: The Fed has been providing price support for long-dated bonds with its large purchase program and low interest rates. When that price support stops and the market has to stand on its own, we expect bond prices to collapse and rates to rise. There is a chance the Fed halts its QE program and raises rates in 2013 if headline unemployment reaches 6.5%, which is within the realm of possibility given the current trends in jobless claims. As a result, we find long-dated bonds extremely risky and prefer floating rate, short-duration and international bonds.
  6. The Sun also rises in Japan: Japan has been mired in deflationary malaise for over 25 years. An entire generation of investors has lived through successive mirages of Japanese recovery. We have begun to believe that this time is different. The enormous growth in Japan’s Asian neighbors and its own robust legal institutions make it an attractive destination for investment, tourism and business partnership. Japanese businesses are taking advantage of these opportunities, and though China still possesses a cost advantage, the gap is closing as wages rise in China. We see Japan’s demographics stabilizing and a generational change underway in Japanese business creating an entrepreneurial surge. We believe this presents an attractive opportunity for equity investors.
  7. Gold: Our regular readers know that we are not enamored of gold. Fiat money has served the world relatively well and provides policy makers with some flexibility. Competing fiat currencies and the opportunity to invest in both real enterprises (via stocks) and geographic communities (via government bonds) provide the modern investors with a variety of options to store wealth. We continue to hold that the price of gold is elevated beyond fundamentals and not sustainable. We see demographic changes that are steadily eroding Asian demand for gold, removing this long ranged support. We expect gold prices to drop in 2013.
  8. The death of the PC has been greatly exaggerated: 2012 was the year when smartphones and tablets decisively pushed desktop computers from their perch as the primary electronic devices in most homes. Relatively low prices, accessible touch-screen interfaces, wireless internet access and rich functionality are making small devices the desirable option for more consumers. Despite being overshadowed by its cooler, touch-sensitive cousins, the traditional computer remains the one device capable of performing the whole range of computing functions. It will remain an essential business tool for years to come. We think it’s a little too early to call the death of the computer, and that certain PC-related stocks will outperform in 2013.
  9. Network everything: Though wide access to the Internet is well into its second decade, connected devices have yet to reach their ultimate potential. Over the course of the next decade, we expect to see more devices linked to the broader Internet for specialized and general function. This will include cars and household appliances, opening up new use cases and opportunities for businesses positioned to produce the right set of products and services. We believe the technology sector in general, and Internet infrastructure firms in particular, offer attractive growth potential over the next decade.
  10. Alternative Energy: Alternative energy businesses have suffered significant losses since 2009 due to a variety of reasons.  In the three years since, a couple of trends have converged to make their future look much brighter. Alternative energy at utility scale is approaching cost parity with conventional energy generation, and a nascent environmental movement is developing in the emerging world. These two trends are changing the equation for alternative energy and 2013 should see an increase in investment flows towards non-conventional sources of energy. We think prices are relatively depressed and the sector offers attractive value for long-term investors.
2012 Investment Themes Reviewed

2012 Investment Themes Reviewed

2012 Themes: The More Things Change.


Since we’ve now closed the chapter on 2012, we’d like to review our “10 economic themes for 2012” from last January to see how well our ideas performed.

We’ve graded ourselves using these symbols: ? Right,  X Wrong, ? Not Exactly.

  1. ? Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election… We were largely right here. The Fed held rates steady ahead of the presidential election. We will admit to being surprised at the robust extension of QE as we did not expect the Fed to make as controversial a decision only a few months ahead of an election.
  2. X Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors. We were flat out wrong here. Both stocks and bonds performed well in 2012. Stocks did well as vast amounts of monetary support helped lift demand from depressed levels. Bond prices were supported by the Fed’s steady purchases over the course of the year, and investors’ rediscovery of the appeals of fixed income.
  3. ? Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis… We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value.  We are giving ourselves a half point here.  Greece did not default, even though private Greek bondholders will have to settle for 50 cents on the dollar.  However, by strong-arming creditors to accept the most draconian restructuring in recent history, Greece has managed to avoid the imprimatur of default. Greece continues to struggle and there is a another restructuring possible in 2013.
  4. ? Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed. We were wrong here.  The Euro did indeed weaken by 10% over the summer, but by the end of the year it had made up the loss.
  5. ? Blue States/Red States: This is a two part theme. The presidential election cycle should be the major story in the US in 2012. In our view though, the more critical issue is the associated discussion about the US and individual state debt burdens. The charmed baby-boomer generation will have to decide how much of a cut in benefits is acceptable to ensure the burden of their entitlement programs in coming years does not doom the economic future of their children and grandchildren… Surprisingly the presidential election did not settle these issues. The topic remains hotly debated in Washington and the prime driver of US bond markets. Rating agencies continue to scrutinize every move in Congress with an eye towards the country’s AAA rating.
  6. ? Chinese Math: At the 18th Communist party congress, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required in China as it moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels. We give ourselves a qualified right on this one. There are signs that the Chinese economy is faltering, and real-estate prices have begun to fall.  But none of these has occurred to the extent we had anticipated.
  7. X Revolutionary Times: …We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year. No doubt, 2012 was full of political upheaval and this was reflected in the markets with many sectors seeing large swings over the course of the year.
  8. ? Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources… Oil had a tough time rising despite extreme uncertainty in the Middle-East, it is still around $100. We give ourselves a draw on this one.
  9. ? Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance)… We were largely right here, with some of the more questionable business models (like GroupOn) falling out of favor with investors. The most significant Internet IPO of the past five years (Facebook), was overpriced at issue and dropped significantly in the first few months.
  10. ? Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in 2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis…  We were largely right here, the US housing market continues to languish at low levels of activity with prices not far from the lows in most markets.