July 7, 2004
After a year of soaring stock prices, investors have
been marking time since the beginning of this year.
For example, a group of 186 closed end diversified equity funds
experienced a 16 percent gain in their net asset values during the last six
months of 2003. In the first
six months of 2004, the gain has been 1.8 percent.
Ninety-eight closed end international equity funds
increased their values by an average of 28 percent in the second half of
2003 and lost one percent so far this year.
Bond funds have lost money since the beginning of this
year while money market funds, while not losing, have returned less than one
Clearly, there have been exceptions.
The median home appreciated in price by nearly 9 percent in the past
twelve months. With the average
family having a mortgage of more than 50 percent, that provides a nice
double digit return on home equity.
Some countries, such as in Eastern Europe (including
Austria), Mexico, and Japan, have been winners; but China and India, two of
the fastest growing countries in the world, have not been good investments
so far in 2004.
Some hot technology sectors, such as broadband, the
internet, and wireless, have continued to soar. But semiconductors, which provided almost 40 percent gains in
the last six months of 2003, have lost about 13 percent so far in 2004.
Even within that group, Taiwan foundries have increased in value
while other foundries have, well, foundered.
I cannot predict what the best investments will be in
the second half of 2004. If I
could, I would be much wealthier than I am.
However, I have several rules that I tend to follow (at
least when I am at my best, which is advising others).
First, what are happening to the key determinants of enterprise value in an economy? Are future profits tending to intensify (meaning the business cycle is just beginning to surge) or are they stagnating (as the economy gropes for direction). Also, are interest rates beginning to rise, or are they stable or declining?
If profit growth is slowing and interest rates are
rising, that is not very conducive to rising equity values. However, the above examples show that even if the overall
economy is not helping equity values, there may be sector or geography
specific conditions that are. So,
Second, are there policy changes that are helpful or
hurtful to enterprise development? For
example, the correct time to invest in China is when they were admitted to
the World Trade Organization. Now,
the advantages from that move have been absorbed.
In Eastern Europe, inclusion in the European Union has aided the
export prospects of those countries.
Third, are there sectors or geographical areas that are
providing superior returns without exposing investors to superior risk?
I actually looked at the 3, 5, 8, and 10 year performances of a host
of open ended mutual funds. The
best performances without much risk as measured by the variation in annual
returns over that time were managed international balanced funds (meaning
both equities and bonds) and small capital managed domestic funds.
Fourth, if I do not believe I have expertise to allow
me to beat an index, then I invest in the index.
You will notice that some managed funds actually outperformed the
index funds with less risk. However,
they might have greater tax consequences than the index funds.
Fifth, tax savings is an addition—not the reason for
my investment decisions. I
certainly want to extend my winnings and not pay taxes if possible. As a result, I do most of my stock trading in my IRA, where
gains are not taxed until funds are withdrawn from the IRA. My long term investing is in my personal account, where I
hold until I no longer expect my positions to provide acceptable rates of
return over time.
Sixth, last year’s winners are last year’s winners.
I am investing for next year’s winners.
Is there a reason why they can be the same, as internet applications
clearly have been? Is there a
reason why the laggards should remain behind?
Apparently, investing in the 5 worst Dow stocks of the past year
provides stronger returns than investing in last year’s 5 best performers.
There are more but I will just tell you my conclusions.
I believe there will be a legitimate second leg to this bull market
that will provide 10-12 percent returns in the next year.
I believe the gains are slightly more likely to occur domestically,
although I still like Japan and Eastern Europe.
The laggards of pharmaceuticals and telecommunications are where I
see value. The previously
strong materials, including this year’s surprise winner of energy, should
And I also hope I will win the lottery, if I ever get around to purchasing a ticket.