The Challenge of 2004

We measure our investment performance using a reference account that, throughout the last twenty-seven years, has represented a significant (though thankfully declining) percentage of the assets under our management. It presents the added advantage of having had its performance figures audited without interruption since 1976. Finally, we believe that it fairly reflects our firm wide investment style (see: Investment Style and Market Cycles). Our returns are presented after deduction of our fees and, for the S&P 500, include the re-investment of dividends.

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By any measure, 2003 was an excellent year for our clients, and consequently also for Tocqueville itself.  

Audited figures for our reference account won’t be available for a while, but our best estimate is that it closed the year 2003 with a gain of 43.1%, against 28.7% for the S&P 500. This performance was even more gratifying coming, as it did, on the heels of the 2000-2002 bear market, during which our reference account actually gained 3.08% while the S&P 500 lost 37.60%.

As for Tocqueville, in good part thanks to the performances of our clients’ portfolios, its total assets under management passed the three billion dollar mark and it earned record revenues and profits.

All this good news would be enough to bring the contrarian that I am to the verge of panic. But they are not my only concern.

Contrarians No More

As bottom-up, value investors, we usually put more trust in the analysis of company fundamentals and the valuation of individual stocks than in our guesses about the economic outlook.

However, we also pride ourselves on being contrarian, which often involves views about whole industries or even the overall economy. Most of the time, these macro views serve only as a backdrop to our stock analyses, but occasionally they are so contrarian as to compel investment decisions. This is what happened about two years ago.

In the midst of the bear market, we began to envision how the ultimate recovery might unfold. A scenario took shape, involving a synchronized global recovery; an economic boom in China, with the emergence of that country as a major importer; the resulting revival of commodity prices; and a weak dollar.

While investor pessimism grew along with the declining markets, evidence kept accumulating behind the headlines that made our scenario more and more compelling. This, in turn, led us to make choices that were, more than usually, influenced by top-down, macro-economic considerations.

These, more than traditional value criteria, were the reasons why we entered the year 2003 with portfolios heavily invested in commodities producers, gold, energy, basic industries dependent on the rate of industrial production, selected technology companies and, where appropriate, Japanese and Asian emerging market companies.

One of my concerns is that, in the past year, events and investor sentiment have caught up with our once-contrarian economic scenario, so that our favorite sectors have now also become market favorites. Having not changed our economic outlook, we find ourselves in an uncomfortable position for contrarians: squarely in the midst of the consensus.

It’s Hard To Be Contrarian Today

Today’s consensus of economists and market seers for the year ahead is especially unanimous and compact. It envisions good economic growth, both in the United States and abroad – with a buoyant first half to be followed by a more subdued, but still decent second half. A strong rebound in global corporate profits should lead to both employment gains and recoveries in capital spending.

In spite of this, inflation is not expected to become a concern any time soon, so that monetary policies can remain accommodating – in the United States because the Federal Reserve will not want to upset the apple cart before the elections, and abroad because the strong Euro and Yen argue for rate cuts rather than monetary tightening.

In such an environment, bond rates may edge up rather than soar, while stock markets are expected to do well, especially in sectors sensitive to economic activity, where profit growth should more than offset the likely downtrend in price-earnings ratios. Views on commodities, including oil, are a bit more varied, but few observers expect them to collapse from recent near-record levels.

Much as we would like to disagree with this consensus, as contrarians, we find little to say but: “Amen!” Any negative scenario for the world’s economies in 2004 would have to assume some kind of accident which, while always possible, cannot by definition be predicted.

Beyond 2004, however, the general optimism seems to evaporate. Not everyone foresees recessions or bear markets, for sure, but the general tone is one of caution. 2005 is widely seen as the year when we start paying the piper and coping with the world’s longer-term problems: America’s gaping deficits (domestic and foreign) and mounting debt burdens; China’s overheating or supply bottlenecks; the dollar’s expected continued fall and the Chinese Renminbi controversial undervaluation; Europe’s political tensions and institutional contradictions; mounting inflationary pressures and the likelihood of central banks tightening, among others.

Since these gathering clouds are well anticipated and will promptly be recognized, the consensus view is that financial markets may top out early – some time around or before America’s November presidential elections, for example. Here again, I find it difficult to argue with the need to correct some of the world economy’s major imbalances. Timing, however, is something else, as the following flashback will remind us.

Flashback to the mid-1970s

The New International Economic Order involves far more than higher prices for oil and other third world raw materials. It connotes a movement by Europe and third world countries both to become independent of the U.S. economic orbit and more closely integrated economically and politically with one another. In the realm of international finance, it promises an alternative to the dollar standard, hence a winding down of foreign credits to the U.S. Treasury and other Federal Agencies.

The preceding quote is from a 1977 book by Michael Hudson, entitled Global Fracture, which I recently rediscovered while putting some order in my bookshelves. It could have been written last month, along with my paper Un-building Blocs. And of course, in 1976, I too had written “Between Inflation and Deflation: The Dislocating World Economy”.

That long report, like Hudson’s book, was well documented and, I think, its analysis clearly articulated. But the point is that neither of these writings actually preceded a major collapse or crisis: the Big Event had already taken place in the early 1970s, with the breakdown of Bretton Woods, the collapse of the dollar and the ensuing inflation and global recession. Rather, our analyses were useful backdrops to understanding the several years ahead, when economies would struggle along and markets would consolidate without much gain or loss.

As I recently argued in Flashback to The Late 1970s, the next several years may very well be reminiscent of this earlier “digestive” period.

Value Is a Challenge, Too

In the absence of strong contrarian convictions at the macro-economic level, we must fall back for new investment ideas on our other discipline: bottom-up “value” investing. But outstanding values are not so easily found either, these days.

Take the United States, for example, where 2004 estimates for the S&P 500 index’s earnings have been creeping up. There is a whole menu of definitions of earnings to choose from – “operating”, “reported”, “core”, etc. – with estimates ranging from $44 to $63. But, at today’s prices, even the most generous of these estimates yields a price-earnings ratio of 18 times 2004 earnings. While this is not outrageous in view of the low level of interest rates, the risk lies precisely in a rise of interest rates and its corollary, declining price-earnings ratios.

In Asian emerging markets, where we used to be able to buy companies with a credible growth rate of 20% or more for 6 to 8 times earnings, we now have to pay about twice that. At these higher levels, one must wonder if the remaining valuation discount is enough to make up for the lack of predictability inherent in emerging economies.

In Europe, we find some medium-sized companies that are world leaders in business niches and yet sell at attractive valuations. But it is hard, at this stage, to fully evaluate the ultimate impact of the higher Euro on their sales and earnings. Similar considerations apply to Japan, where our commitment two years ago represented a leap of faith on recovering corporate returns on investment, which have begun to materialize.

Of course, market averages are not particularly relevant to bottom-up stock picking. However, the range of valuation ratios is also particularly narrow, these days, probably indicating the lack of conviction of analysts about companies’ quality or future growth.

For example, the Leuthold Group regularly measures the price-earnings ratios of a sample of 3000 companies. At the peak of the bubble, the median price-earnings ratio of the largest 100 companies in the sample stood at 34.6, far above the 16.5 median for the 2000 smallest companies. Today, these two groups’ respective median price-earnings ratios are almost the same, at 18.4 and 17.7 respectively.

It is likely that, at the next market peak, divergences will have grown again between various categories of stocks, as some groups gain the fancy of investors and start being priced for perfection and higher growth into the indefinite future.

Constructive Inaction

It is my avocation, and I hope my contribution to our investment process, to try and imagine what a contrarian outcome might be to various situations. In doing so today, I am struck by a couple of observations.

First, despite the widespread optimism about early 2004, I detect a strong current of long-term pessimism underlying most of today’s rosy forecasts. In a way, this could be interpreted as the wall of worry that all bull markets are condemned to climb, perhaps indicating that the current one is not over yet.

Second, I am always suspicious of economic scenarios that can be articulated too easily and are readily supported by ample available data. These are the scenarios that are incorporated into current market prices, and there is little money to be made betting on events that are widely anticipated. Today’s pessimistic scenarios about the future generally fall in that easily-explained, well-documented category.

True contrarian scenarios are usually harder to put together and can only be supported by “straws in the wind”, e.g. a slow, tentative accumulation of circumstantial and incomplete evidence. Paradoxically, on the heels of a very strong stock market year, it seems to me that the true contrarian today would be wildly optimistic – not just about the next several months, but about the next several years.

We have not yet developed a strong enough conviction to totally fall in that exuberant camp. But it certainly seems to make sense to let our winners in the cyclically-sensitive sectors run, at least as long as the synchronized global recovery continues to gain momentum.

I believe it was veteran contrarian James Fraser who once said that there are times when “constructive inaction” is the best approach to the stock market. He did not refer to indecision, but rather to a rational process of elimination that left inaction as the most positive choice. If you are invested, as we are, in sectors that should benefit from a continuation of current trends, today may well be a time for such constructive inaction.

François Sicart

January 20, 2004
^© Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management.  Nothing herein constitutes investment or any other advice and should not be relied upon as such.  This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities.  Any reference to past performance is not necessarily a guide to future performance.  Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.  The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.