Sorry Warren, Active Management Is the Way To Go

If anything was proven this week it was that outperforming the markets is all about stock selection. Warren Buffett, the sage of Omaha, has decided that when he passes he wants his fortune managed by index funds. He has stated time and again that indexing will outperform active management over any reasonable time frame. To back up his beliefs, he has placed numerous bets along these lines and won. Well, why doesn’t he do it himself? The answer is that he and his team at Berkshire Hathaway can outperform the indices and he has been doing so successfully over his lifetime.

We returned to managing money a few years ago when the hedge fund sector was under tremendous pressure for having under-performed for so many years. We did so to make a point. We were out to show that a well-managed global hedge fund could still outperform all indices as we have successfully done over our 40-year career – much like Warren who I know and deeply respect.

Paix et Prospérité has outperformed all indices by a mile and the hedge fund index by many, many times.  It all comes down to management! Not all managers are alike. In fact, the first decision that I have to make when considering an investment in a company is the caliber of the management. I have said many times that bad management can screw up a great business and good management can succeed at all times when most can’t.

AI (artificial intelligence) cannot replace people as investing requires that we look through that proverbial windshield rather than the rear view mirror. AI has history and predictive algorithms. Good managers have history, evidence-based principles that inform forward-looking strategy, and a healthy dose of intuition which never hurts.

If you did not notice, the OTC market significantly outperformed the S&P and DJIA last week as several of the big tech names, GOOG, INTC and MSFT as well as AMZN, reported great numbers and took off on Friday. The mundane traditional sectors like box retailers on the NYSE got killed as JCP came out with an announcement of horrible earnings. Most of the disruptors with a great future are on the OTC while the more traditional companies are on the NYSE.

What if CVS and Aetna merge? Do you know why this is potentially happening? It is their fear that Amazon will enter the drug distribution business. Disruptors are everywhere causing well-established old-line businesses to turn upside down, inside out and potentially out of business. Just ask Sears! And why do you think that the broadcasters/newspapers are having difficulty? Netflix and Facebook, and other disruptors, are besieging their advertising business where they make the bulk of their profit. Can passive management and AI forecast the demise of these businesses while simultaneously anointing the new winners? That is what a successful active global hedge fund manager can do as these new trends emerge globally.

The backdrop for the global stock markets remains excellent: global economic growth is clearly accelerating without inflationary pressures; monetary authorities remain very accommodative although some plan to reduce, but not eliminate, their stimulus down the road; interest rates remain ridiculously low for this stage in an economic recovery but the global yield curve is steepening which is good for financials; and earnings growth is better than expected in the aggregate as unit volume growth is improving while costs stay controlled. And to top it all off, the prospects for tax reform occurring this year or the beginning of next is getting more likely by the day which will boost S&P reported earnings up by around 11% overnight.

Let’s review what was reported last week to see if it supported or detracted from our economic and investment view:

1.) The United States is growing in importance in our overall global view, as it becomes the engine for accelerating growth continuing next year. We expect tax reform will be passed creating some certainty for both businesses and individuals to plan and move ahead. We were pleasantly surprised that third-quarter GNP growth grew by an above-forecast 3% as consumer spending increased by 2.4%, penalized by the hurricanes; business fixed investment rose by a robust 3.9%, net exports grew by 2.3%, government spending fell by 0.1% and core prices, excluding food and energy, increased by 1.3%. Consumer sentiment was reported on Friday and remains at a very high index at 100.7 with the index of future expectations increasing to 90.5 from 84.4 last month.

The key event of the week was the House passing the 2018 budget last Thursday. Both the House and Senate Republican leaders are aiming to pass tax reform legislation by Thanksgiving and a final bill on the President’s desk to sign by the end of the year or early 2018. Our fingers are crossed but we definitely see progress on Trump’s pro-growth, pro-business agenda. “What if” really appears to be “what will be.”

2.) I continue to believe that China offers tremendous long-term opportunities to profitably invest as long as you invest in those sectors with the wind to their back with the support of the government emphasizing the consumer and technology sectors. President Xi said that the government would focus less on the speed of economic growth and more on the quality of growth. That means that he will move to increase the standard of living for all. Excessive pollution and speculation will be reduced and financial capital ratios and liquidity will be increased so that the foundation for the future is strengthened. China issued its first U.S. dollar-denominated debt sale in 13 years priced with a yield of 2.678% or just 0.25% above comparable Treasury yields.

The next important event to monitor will be Trump’s trip to China next month. I expect many positive things to come out of their meeting especially trade-related to avoid future trade conflicts down the road.

3.) The ECB met last week and announced that its overly accommodative policy will ebb over time but not too much and not too fast. Under its new plan, the ECB will reduce its purchases to 30 billion Euros per month down from its current rate of 60 billion, keep its rates constant for now, and extend its buying to the end of 2018. “This is not tapering; it’s downsizing” Draghi said, which says it all!

The OECD raised its forecast to 2.1% growth this year slowing to 1.9% next year, which we find conservative. It’s more important to note that business investment is likely to increase by more than 7% this year, a new record, and indicative of a new spirit in the Eurozone who tend to be very conservative.

4.) It is clear that the Saudis’ want to prop up the price of crude before capitalizing and selling a piece of Aramco so it is no surprise that Saudi Arabia and Russia, a country in dire need of funds, is willing to limit oil output thru 2018. Expect the price of crude to remain artificially supported until then but as long as the price of crude stays above $50 per barrel, U.S. shale production will continue to rise.

Let’s wrap this up.

The wind remains to your back investing in global stock markets as long as the monetary authorities are creating more capital than are needed for the real economy. But neither all markets nor all industries or stocks will benefit. A successful investor must be able to fully understand what is happening in each region, both economically and politically, and how it will impact not only its own country and its people but also all others. There are clear winners and losers here and also as you need to drill down amongst industry groups and finally amongst companies. There is no way that passive or artificial intelligence can adjust to change quick enough to adjust their capital allocation, regional emphasis and industry selection to reflect such rapid change as is occurring now.

The bottom line is that wind remains at our backs so the path of least resistance for most stock markets, especially the U.S. where tax reform is on the horizon, remains up.

I was asked to comment on the emerging markets, which have outperformed this year as they have underperformed for so many years before. Most emerging market countries emphasize production over consumption so acceleration in global growth is welcome and tremendously beneficial to their companies’ earnings. It will only get stronger in 2018 but we emphasize only stocks that we can follow and monitor closely ourselves so we do not dabble in these markets. It’s tough enough following Alibaba and others, which we have owned for years.

We continue to emphasize the large money center banks like BAC, C and JPM; global industrials like EMR, GE, HON, IR, FTV, and UTX; low cost industrial commodity stocks such as BHP and RIO including U.S. low cost aluminum and steel companies such as AA and NUE; technology at a fair price such as CSCO, MSFT, NVDA and ORCL special situations such as DWDP, FMC, HUN and PX and others.

Do as Buffet does and not what he says!

So remember to review all the facts; pause, reflect and consider mindset shifts; review you capital allocation and risk controls; do independent research on each idea and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC



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