InvestRationale: My 2007 approach, corrective actions and tweaking the outlook

By mid 2007, it was time to re-look at the portfolio, adjust it and update the view on macro factors to consider. Here is my 2nd take at investment in my notes to my wife on the subject Analysis of our portfolio: over/under-exposure by sector/economy/type of companies - 2007

• Greater exposure to growth of emerging countries (especially of China) than of US, Europe and Japan
• Success of current portfolio dependent on China/Pacific – very high; Canada – very high; US – medium to high; India – medium; Latin America – low to medium; developed Europe – low to medium ; low to medium; Japan – low to medium; Eastern Europe – absent; Africa – minimal; middle east - absent
• Oil & gas play very significant; materials are a step behind; tech - 3rd and fin – 4th
• Good strong largely stable techs
• Minimal health; low on discretionary, consumer, staples, durables, low on pure infrastructure, no significant bets on cutting edge unproven tech, bio-sciences,
• Large caps play almost completely globally, in US or in Canada; Significant dividend play story except MDA, PD, TLM

Factors about the stock market to consider as we go in for a fresh round of buying – reflecting on analysis made earlier (most of which did very well)

• Bull run for 4 years currently on; typical runs are for 3-4 years; is market on last legs?
• Or is it a long run like the 1950s and the 1990s – that is the trillion $ question
• Bearish view– too many people chasing gains, making riskier bets, M&A frenzy, emerging and foreign markets becoming larger part of the portfolios in the US and Canada households, US Housing market in reverse, deficit at the highest; oil prices will kill consumer and emerging country confidence; credit risk will move from Housing to Private equity to full market and the credit squeeze will slaughter us; democrats will ruin market especially Defence, health, energy in the US; Democrats will bring up trade barriers slowing global economy; China will be punished and costs in world economy will again rise as China’s deflator goes away
• Bullish view – US no longer runs the world, China, India and Asia matter and will keep the world up as they grow; Lat Am in great shape unlike before; Europe and even Africa doing well; mid-east – too rich so lots of money for equity available; current consumer data in US still up
• Humans in investing generally gloss over bad news and take more risks in market than they would in any other aspect of life
• We are young and can make a few mistakes and suffer losses in the immediate to mid term as long as our bets are real
• Most investment to be made will be in USD so currency loss could be a factor and prevent locking on gains or aggravate losses till USD rises against CAD; question crucial to answer
• One thing is sure that the market is nervous and there will be crashes at the smallest bad news and that will present buying opportunities so we need our portfolio ready for that bad day – the prepared mind like the furrowed fields prospers

My view of the world economy as a backdrop to the investment approach, based on some reading, some listening and the gut feel – 2007 analysis

• US economy has shown amazing resilience in the face of the bursting in 2000-01 of the biggest stockmarket bubble in history, of terrorist attacks and of a tripling of oil prices; flexible wages and prices, rapid immigration, a sounder banking system and globalisation as factors that have made the economy more resilient to shocks.
• Part of America's current prosperity is based not on genuine gains in income, nor on high productivity growth, but on borrowing from the future.
• As a result of weaker job creation than usual and sluggish real wage growth, American incomes have increased much more slowly than in previous recoveries.
• Central banks in Asia and oil-producing countries have so far been happy to buy dollar assets in order to hold down their own currencies. However, there is a limit to their willingness to keep accumulating dollar reserves.
• Given that consumer spending and residential construction have accounted for 90% of GDP growth in recent years, it is getting difficult to see how this can occur without a sharp slowdown in the US economy.
• Last year, emerging countries’ GDP grew in current dollar terms by $1.6 trillion, more than the $1.4 trillion increase of developed economies. And there is more to this than just China and India: these two countries together accounted for only one-fifth of the total increase in emerging economies' GDP last year. Vietnam, Brazil Russia, Middle East, Easter Europe and even other Asian countries are joining in. People are now talking of BRIC plus N-11 which includes Pakistan, Vietnam, Bangladesh etc
• Emerging economies have also become increasingly important markets for companies from the rich world. Developed economies' trade with developing countries is growing twice as fast as their trade with one another. Over half of the total exports of America, the euro area and Japan now go to emerging economies. The EU exports twice as much to them as it does to America and Japan combined.
• Of course, with half the world's output but five-sixths of its population, emerging economies still have incomes per head far lower than the rich world. Their share of exports has more than doubled since the 1970s. Over the past five years, they have accounted for more than half of the growth in world exports. On the other hand, their stock-markets still account for less than 20% of global capitalisation.
• Unlike many previous booms, the emerging countries’ current expansion has been financed largely by domestic saving rather than debt: their average ratio of foreign debt to exports has fallen and they have built sizeable forex reserves.
• However, some of the recent boom in emerging economies is due to three factors that may be unsustainable. First, rising commodity prices have given a fillip to producing countries, such as Russia, Brazil and South Africa. Second, low interest rates have reduced debt-service costs—especially important for Latin America, where the debt-to-export ratio is twice as high as the average for emerging economies. And last, exports have been boosted by America's strong import demand. This favourable environment cannot last: interest rates are rising, and American consumers cannot keep spending more than they earn. Emerging economies' energy-intensive heavy industries are also vulnerable to high oil prices. A saving grace is that these risks partly offset each other. A slump in American demand would reduce both interest rates and oil prices.
• Perhaps the biggest risk is that the boom may encourage complacency and reform fatigue. Yet further action is needed, from greater fiscal discipline to more flexible exchange rates. India an China are still leading the fight to keep economies closed.
• The future expansion of emerging economies will not follow a straight line. It is unavoidable that emerging economies are more prone to economic ups and downs and financial bubbles, as America was during its entry on to the global stage in the late 19th century.
• My pet concern re emerging countries - local political challenges, fear in Western World and reaction possible (highly probable)
• However, the long-run prospects for emerging economies as a whole look excellent, so long as their move towards free and open markets and sound fiscal and monetary policies continues. Get these basics right, and developing countries ought to outpace advanced economies. Because they start with much less capital per worker than developed economies, there is huge scope for boosting productivity by importing western machines and know-how.
• Globalisation is causing the biggest shift in relative prices (of labour, capital, commodities and goods) for a century, and this in turn is causing a significant redistribution of income. Low-skilled workers in developed economies are losing out relative to skilled workers. And owners of capital are grabbing a bigger slice of the cake relative to workers as a whole.
• As a result of China, India and the former Soviet Union embracing market capitalism, the global labour force has doubled in size. To the extent that this has made labour more abundant, and capital relatively scarcer, it has put downward pressure on wages relative to the return on capital. Throughout the rich world, profits have surged to record levels as a share of national income, while the workers' slice has fallen. Hence western workers as a whole do not appear to have shared fully in the fruits of globalisation; many low-skilled ones may even be worse off. But this is only part of the story. Workers' wages may be squeezed, but as consumers they benefit from lower prices. And as shareholders and future pensioners, they stand to gain from a more efficient use of global capital. Competition from emerging economies should also help to spur rich-world productivity growth and thus average incomes.
• The profits boom has been fuelled by globalisation. The emergence of China and India, with their vast, cheap labour forces, has weighed on labour costs in the West, as well as keeping a lid on inflation and interest rates. But there is a flipside. The demand for raw materials from China and other fast-growing emerging economies is now posing a threat to profitability, as commodity prices rise.
• Russian, Indian and Chinese stockmarket subject to significant fraud and manipulation as well as regulatory crackdowns.
• Fire in the belly to do better in East Asia, India, China, Eastern Europe.
• Less wastage in middle east – education, health and infrastructure being recognized as focus areas.
• China rules: Even though China is investing at the staggering rate of 46% of GDP, it is still running a net saving surplus, and that surplus is still growing. Savings, commodity prices, cost of goods, manufactured goods demand driven by it.
• Americans now save less than 1% of their disposable income, compared with a euro-area average of 10%. America's budget moved sharply into deficit, whereas Europe's public finances have seen less change. As a result, America's national saving rate is now below 14% of GDP, compared with over 20% for the euro zone.
• Europe has, in fact, made significant progress on economic reform in recent years. Germany's labour market has become more flexible and the country's social benefits have been trimmed. France's pension system has been overhauled. The market is already reflecting this good news and optimism in Europe.
• A reason for unusually low interest rates is that a large chunk of those surplus savings has been under the control of central banks, particularly in Asia. Thus far, these banks have cared less about risk-adjusted returns than about stopping their currencies from rising. The sustainability of America's deficit and the risk of a hard landing depends on whether they will continue to do so.
• Africa seems to be progressing at grass-roots but Africa and Middle East story not yet captured the market. This is an untapped story.
• Decision making at consumer levels in household very much in control of women and younger people with new tastes will be the other prominent group – various new segments popping up – niches are to be served.
• Entertainment taking up larger part of time of consumers and soon wallet share too in developed countries; entertainment and communication expenses will be even more prominent as people “surge” upwards in developing countries – not education or health as much.
• Baby boomers will cause a need for specialized training, knowledge coaches, recreational needs, health care, religious products in the Americas.