Investing in Tough Times: An Update

The stock market indices show that an average investor suffered a huge loss of almost 50% during September 2008 and recovered about half of this drop over the following twelve months. For this year so far, the market indices have moved sharply both upwards and downwards but in a narrow range. The change of two to three percent in one day’s trading happens at least once a week. Traders have made and lost money but the buy-and-hold types have stayed put at a level one third to a quarter below the peak achieved in the summer of 2008. Investors feel a general sense of relief but there is still a lot of anxiety over what is in store. The questions most often asked are:
1. What does the future hold?
2. How should one invest such that the investment is not wiped out in the next collapse?

The crystal ball I acquired in the Tripoli souk in 1969 is wearing out and the picture it projects is rather fuzzy. For what it is worth, my view of the short and middle terms is more of the same as the last twelve months – volatility governed by the news (or the perception derived from it) but within a range of 10 to 15%. In a move that has been repeated ten times so far this year, indices give up five to eight percent over a few days, then pick up the same amount over an equally short duration. I fear that this volatility is here to stay for a few years.

In the long term the future is clear – gross overpopulation of the planet and rising consumption are not compatible with limited resources which can be grown or extracted with acceptable risk. A disaster in form of a series of natural calamities or a major war is almost inevitable. In reality this is beside the point for investors; one can not invest today based on the danger of a catastrophe sometime in the next decade.

Given the interest rates below the rate of inflation, and even that nominal income being subject to income tax at the highest rate, it does not make sense to stay in cash for an extended period. Sky high debt levels of consumers and all levels of governments in the West and low savings rates make inflation at some point in time very likely, particularly if the economic growth does not resume soon. I would not wish to be trapped in the bonds when inflation is rising. I am not a gold bug but there are many who believe that gold breaking record levels almost every day is an indicator that inflation is not far away.

The opposite of inflation, the deflation, is also a possibility although most economists do not believe it is likely. In a deflation economy borrower businesses and consumers find their debt ballooning in real terms and many are unable to keep up with the payments. . This is what is happening with Real Estate in the U.S. and it is the main cause of the stagnating economy. Deflation puts the financial institutions under great pressure and increases the likelihood of them going broke. Cash under the mattress would perhaps be the best investment in this situation so long as the mattress does not catch fire or attract undue attention.

The basic reason for stable prices in last decade was the fixed Chinese currency even when the manufacturing of consumer goods was shifting to China and the country was accumulating huge trade surpluses. One way to reduce the prospect of deflation and grow Western economies again would be to convince China to let the currency float and reach its proper level, about a third higher than it is at now. This would increase the price of Chinese goods and help the industry in the West grow again. Hopefully the rising prices would be offset by higher employment and wages in private sector will improve after staying flat in real terms for last twenty years. The recession and deflation would be avoided and with some wise management by central banks this would be achieved with an acceptable rate of inflation.

Given that any of these scenarios may present itself, a volatile stock market is to be expected. In an uncertain environment leverage is a dirty word. In 2008 crises highly leveraged investment companies and individuals were wiped out as they have been in every precipitous drop in the market. In current situation, prudent investors will watch the leverage and eliminate it at the first indication of danger. That applies to investment in real estate as well as stocks.

The best performing investments are likely to be the well-balanced portfolios. Incidentally, investment in just one or two stocks is risky. The portfolios with ten or more evenly distributed holdings in diversified industries have the least downside risk and best upward potential. There is no harm in starting with one or two stocks, you have to start somewhere, but the intention must be to expand the portfolio sooner rather than later. A portfolio of $50,000 or more should be divided in four parts:

1. 30 – 35% in income trust units. Hydrocarbon prices are subject to too many non-commercial factors and oil and gas income trusts carry higher risk. The units have to be selected carefully for sustainable payouts and, whenever possible, from different industries. The top performers in my portfolios have consistently been the income trusts, even during the 2008 crisis. After the end of this year almost all income trusts will convert to high dividend paying normal corporations. The dividends are expected to be smaller than payouts now but will be eligible for dividend tax credit. The tax credit is not available in registered plans therefore their desirability in such accounts is somewhat reduced, though not eliminated. Many investors are afraid that the unit price will drop after conversion. However, this has not been the case with most of the companies that have converted so far and these fears do not appear to be justified.
2. 25 – 30 % in high dividend (four percent or higher) common shares in various industries. Preferred shares have the same problems as the bonds and they have no space in my books. The financial sector should be underweighted because the economy is not out of the woods yet and no one knows what the new regulations would do. This part of the portfolio has consistently been a better performer than indices.
3. 20 – 25% in ‘growth’ stocks, either the companies going through hard times which they are likely to survive or the ones with great growth potential. Occasionally some do go under (Nortel) but the survivors make up for the losers. The companies who pay some dividend are preferable. These stocks do relatively well in inflationary environment.
4. A small percentage, no more than 10%, in rank speculative stocks, juniors getting a foothold in businesses with good prospects or former stars which have been written off by other investors. It is crucial that the portfolio has several holdings of this type. Risk level becomes unacceptable with just one or two such holdings. Individual stocks of this type occasionally increase several fold, some go out of business, others stagnate till they boom or bust. Overall, this part of the portfolio provides a great deal of excitement but performs inconsistently. Investors must be careful to avoid the temptation of overloading on these charmers.

In my experience of investing over forty years, portfolios consisting largely of stable companies paying significant dividends are most likely to provide the best returns in good times and bad. Final word of advice, leverage is dangerous in uncertain times and must be carefully watched.