Marcus Cake

Alan Kohler recently published an article titled “Watch the ball” in June 2006. The articled discussed the recent “correction” and offered a number of long term investment themes to pursue. I do not follow the short term movements in the share markets. The article appealed to my interest in economics and geostrategy. I believe the recent correction is a “Tipping point” that will usher in an era of investing in a rising inflation environment. This will have a dramatic effect on portfolio weightings, share price valuations and private equity. I will extract a few comments and then offer a few additional observations.

The market has moved 50 points, or more than 1%, each way and I think that is likely to be the pattern for months, not weeks. That’s because commodities have not yet had the full correction that they are clearly due for and because there are undoubtedly at least several months of uncertainty about inflation and interest rates ahead.

The volatility in commodity and equities markets during the past month or so is a result of investment funds re-pricing risk in the context of rising inflation, and that process may have only just begun. In fact, investors are likely to be reticent about committing themselves for some time, while markets are likely to remain volatile for months as speculative positions are unwound.

Of course, it’s been a 20-year bull market because of the victory of the world’s central banks over inflation following the Paul Volcker, post oil shock recession of 1982. The previous 20 years produced a long-term sharemarket return of about 7.5%, which was a real return after inflation of zero (the real return of past 20 years has been about 8%). I know it’s hard to think about the next 20 years in the midst of a violent bout of sharemarket volatility and correction, but this is exactly the time when you must. That doesn’t mean you should just buy the index, although given the low fees of index funds and exchange traded funds, you could do worse. That would certainly be better than paying 2% fees for an actively managed fund that will be lucky to match the index anyway.

The best strategy is to build a small portfolio of high-quality, 20-year stocks and not try to time the market.

In my view you should focus on these themes:

• Believe in the long-term growth of China and India, and therefore the commodity super-cycle.
• Think about the impact of broadband internet on all businesses and all households.
• Be positioned for the ageing of the population and the dotage of the baby boomers (they’re just turning 60 now).
• Be prepared for the next great shortage after metals — food.

The most important thing is to not be distracted from basic principles by chasing momentum.

The word “correction” may also be construed as “fall”, “decline”, and “sellers taking profits”. The question I have is a simple one. Will the sellers that took the profits come back and buy? They have in the past. However, the key issue in this article is the assertion that investors are repricing securities for rising inflation. The market will be more volatile and offer less returns.

If we do return to a prolonged era of public markets offering 7-8% annual returns. Investors will be unsure of their approach. Investors have done well over the last decade. We may have greater volatility as investors “explore” investments. Investors need to return to the fundamentals of long-term investing and escape the temptation of “momentum”. Is this a “correction” or is there a longer term change occurring?

Many asset classes are trading at high valuations. It is hard to see investment returns greater than single digits.It may even be harder to earn real returns after inflation and fees. This is likely to drive greater interest in investing in private equity, or direct investment in private businesses. There are many other “assets” that are likely to be “promoted” as “alternative investments” that “may” deliver double digit investment returns. Previously, this included stamps, coins, art and tree farming. There will be even be “innovative” tax schemes that charge management fees and are less concerned with fundamentals of investment returns. In the future, investments that will be “sold” will include the internet, some specific niche technologies, biotechnology and food. Many investors will not understand this and the promoters will sell the “hot” sector, but the company itself may not be “investment grade”. Investors need specialist, independent expertise at a “freelance” cost to invest wisely and economically.

This is a time to fundamentally reassess the long term strategy for an investment portfolio. Others are already doing it. I wonder how many?