Where my inner investor is bottom fishing

In Free by Cam Hui

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I thought that, as a change of pace, I would write about where my inner investor is finding opportunities, instead of focusing on the daily gyrations of the stock market and whether it has found a short-term bottom, which is a topic I will cover in a post this weekend.

The art of bottom fishing requires a strong constitution, which is suitable for people like my inner investor who has a longer time horizon. You have to go into the exercise thinking that you don’t care that you catch the exact bottom, but with a mindset that Mr. Market has put a sale price on an investment. You may buy X at $10, see it fall to $7, but be ultimately rewarded in several years when it rises to $20, $30 or $40 (note that these are just examples and not return forecasts).

With that framework in mind, here are a couple of opportunities identified by my inner investor.

 

Value stocks

Jim Paulsen at Wells Capital Management recently wrote a terrific article about the valuation differences between the high momentum stocks (top quintile of rolling 12 month return) vs. the low momentum stocks (bottom quintile). He called these groups Popularity and Disappointment. The chart below shows the P/E ratios of the two groups, whose spread is getting a bit stretched.

 

The chart below shows the relative P/E of the Popularity vs. Disappointment (solid line) with the SPX (dotted line).

I make the following two observations based on the above chart:

  • The relative P/E ratio is nearing levels where it has reversed in the past; and
  • Reversals in relative P/E ratios have either been associated with bear markets or changes in market leadership, which usually occurs during transitions between bull and bear markets.
I am on record as believing that the bull market isn’t over, but it is in the process of topping out (see The road to a 2016 market top). The second alternative of a simple leadership change is therefore my base case scenario. Incidentally, analysis from JP Morgan (via Business Insider) shows that, despite all of angst over the narrowness of the leadership of FANG stocks (Facebook, Amazon, Netflix, Google), market leadership is by no means dangerously narrow by historical standards.

 

 

Jim Paulsen went on to show that the unloved “Disappointment” portfolio was overweight in Energy, Industrials, Telecom and Utilities, which is consistent with my view that the US economy is undergoing a late cycle expansion.

 

 

The way my inner investor is choosing to play this theme is to buy into value stocks. If you are going to play value, then why not go with the Oracle himself and buy Berkshire Hathaway (BRKb)?  I have written before about BRKb has shown only so-so performance in the last few years and underperformed the market in 2015 (see Is Warren Buffett losing his touch?). The chart below shows the relative performance of BRKb against the market. As the chart shows, BRKb is seeing a minor revival in relative performance, which indicates that 2016 may mark the start of a new Renaissance in value investing.

 

 

Energy stocks

Within the most unloved and washed out parts of the stock market, energy stocks are a stand out. Sure, the supply-demand fundamentals of oil look awful and it seems that every day, analysts are scrambling all over themselves to downgrade their oil forecasts. Here are just a few examples:
  • Citigroup (Ed Morse): Oil could drop as low as $20 (via Bloomberg)
  • Standard Chartered: Oil could hit $10 (via The Telegraph)
  • Dennis Gartman: Oil could sink as low a $15 in a panic (via CNBC)
Then you have this Andrew Thrasher tweet, which is reflective of the washed-out sentiment.

 

 

On the other hand, there are a number of bullish signs for the energy sector. From a technical perspective, the recent action oil prices is constructive as it is experiencing a positive RSI divergence.

 

 

Scott Grannis pointed out that oil prices are extremely cheap when compared to gold. If I am correct about the late cycle expansion, then cost-push inflationary pressures will start to rise and begin to lift the entire commodity complex. The most oversold major commodity in the complex is energy.

 

 

Trying to value energy stocks is tricky at this point, because the E in the P/E ratio is volatile and fading fast. An alternative technique is to consider the P/B ratio, as book value is more constant and useful for valuing integrated oil companies. As Lawrence McDonald pointed out, the sector is cheap on a P/B basis.

 

 

From a tactical viewpoint, I have no idea if the decline stops at $30, $20 or $10. Valuations are sufficiently cheap and the risk-reward ratio is sufficiently attractive for my inner investor to go bottom fishing in the sector. My main focus in the large integrated oil companies that are well-capitalized enough to survive a downturn in oil prices.
My choice in this sector is Suncor, largely because of my inner investor`s innate laziness and the Suncor position in the Berkshire Hathaway portfolio as a signal of its value (see The right way to ride Warren Buffett`s coattails). However, virtually any well-capitalized large cap integrated energy company is probably suitable as a vehicle and so is a well-diversified ETF like XLE.
In effect, my inner investor is make a double bet on Berkshire Hathaway. For someone with a long term time horizon, that`s probably not a bad position to take.

 

Disclosure: Long BRKb, SU

The philosophy of this site can be summarized by a variation of an old adage:

Give a man a fish, he’ll eat for a day.
Teach a man how to fish…he’ll want to get a boat.

I am not here to just give my readers a fish for the day, I would rather help them build their own boat.

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