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HEADLINE ARTICLES 

2004

 

BUY WHAT THE 'BUYERS' ARE

COPYRIGHT © 2009  STANFORD WEALTH MANAGEMENT

IS THE WORLD RUNNING OUT OF OIL?

June 2004

                      In the early 1850s, Samuel Kier, a Pittsburgh druggist, began                       selling  an undesirable by-product of his father's brine wells as "Pennsylvania Rock Oil".  By 1855, he was advertising its scarcity: "Hurry, before this wonderful product is depleted from Nature's laboratory!" it read.  Modern-day Pollyannas have been using this quote and others like it to denigrate the idea that we will run out of oil.  Modern-day Cassandras, on the other hand, find ample “evidence” that the world’s out-of-control overpopulation will strip the earth of every twig, blade of grass, and molecule of oil during our lifetime.  Both are wrong. 

           So just how much oil will our children have?  Think China and India, with 2.3 billion people and counting.   To understand why this is a demo-trend that transcends today’s price per barrel of oil or tonight’s evening sound bites, this month we’ll devote virtually our entire issue to the history of fossil fuel production; an overview of all fossil fuels (not just oil); China, India, and the supply-demand equation; and the effect politics, wars, and alliances have on the mix; and what it all means to investors.       

ASSET ALLOCATION RULES!

 

          (March 2004)                   

                     

                      I use the last word in the headline above as a verb, not a noun.  That is to say, while                       there may be plenty of good "rules" about asset allocation, I mean it in the sense certain teenagers with limited vocabulary and imagination, but boundless enthusiasm, use the word "rock" and "rule" interchangeably, as in "Seniors rock, man," or "Pi Alpha rules, dude!"  I want it crystal clear that, of the three components of successful portfolio management - cyclical market timing, asset allocation, and stock selection - asset allocation rules, dude. 
        Let me tell you why.  Clearly, you need all three components to be truly successful.  Market timing has gotten a bad rap of late as one incarnation of it has been bandied about in the uninformed press ("Hedge funds accused of market timing!  Read all about it!")  But we all "time" the market.  Every time we make a decision to buy or sell a stock, we are saying, "I think this is a good time to buy," or "I think the time is right to sell."  Further, I am not among those timid and pompous money managers who intone, "Buy and hold.  No one has ever timed the market successfully, so why try?” Nonsense. 

           I have timed the market, successfully and unsuccessfully.  Over many years, I've been correct about two-thirds of the time and wrong about one-third of the time. (Witness my keeping clients out of the debacle of 2001 and 2002, but being too slow to rejoin the party in 2003.)  In this business, that's enough of an edge to make a difference between retiring and retiring with enough money to travel, to enjoy life, and maybe fund a small foundation.  When I refer to cyclical timing, I mean "secular" timing, timing the big cycles, and I’ll speak more about it in a future issue.

           For now, let me just say that it's fine if you can sell after a nice rise and while the market is still at a top -- but that isn't human nature.  We want to hold our gains, so we fool ourselves into believing that this is just a "temporary correction."  We hold and hold and hold until the news is so universally bleak that we sell -- typically at a major cyclical bottom.  We claim to be buy-and-hold, but what we really are doing is buying, holding, holding, holding…and panicking out at the wrong time.  Then we disparage the idea of buying and holding - "Hell, I held for twelve years - and look what it got me!"     

       There are three solutions to this conundrum.  First, you can buy and hold - and really hold.  Period.  Through thick and thin, for the long pull.  It isn't easy but it will give you a good, if not a great, return.  Second, you can do as we do and recognize that the mean period of time the market goes up is 33 months, the mean period of decline is 17 months.  Now that provides only the vaguest clue about market timing, since you'll almost never see these exact dates.  But it does alert you to the fact that there is a sine curve that laces its way above and below the general up-trend of the markets.  If you can get two out of three of those multi-month and multi-year sine curves right, you've added hugely to your potential return.  And, third, you can allocate assets in such a way that, even if you're wrong on the direction of the market, you're in the right sectors and the right industries for the times. Asset allocation rules.       

           So what are the right sectors to allocate assets into?   The standard asset allocation models use style or size or geography to help you allocate where to put your assets.  That is, most models rely upon diversification by geography - 70% US, 30% foreign, for example - or size - like 40% large caps, 30% mid-caps, and 30% small-caps - or style, like the old 60/40 - 60% in stocks and 40% in fixed income.  All of these come with endless modifiers and qualifiers and sub-allocation models.  For instance, the 60/40 portfolio is often rebalanced based upon one's age, the assumption being that, as we get older, we have more assets to protect, and capital preservation becomes, year by year, more important than asset growth.  So if we subtract our age from, say, 110, the resulting number is the amount we "should" place in equity investments, with the remainder in fixed income.
       These purely mechanical methods of asset allocation are better than no discipline at all, but my enhancement to the usual asset allocation models makes more sense and provides better returns. 
       I believe we can all discern what I call demo-trends that are changing our world.  Forget for the moment small-cap vs. mid-cap vs. large-cap.  Forget foreign vs. US or fixed-income vs. equities.  I look at all those, but only after I decide what broad industry groups deserve my attention. 
       For reasons well-discussed in years of previous issues, I like health care.  (For new subscribers, the short reason is that we are getting older and want to live a quality life as long as we can.  Health care firms profit from this.  Common sense rules.)       

           I like Asia.  (This part of the world is racing headlong to join the industrial revolution and benefits from its cheap and hard-working labor force.)       

           I like energy.  (As people get a few coins in their pocket, they'd rather bicycle than walk, motorbike than bike, and drive a car rather than do any of the preceding.  They need roads and airports and airplanes and ships to move goods - all of which require fuel.) 
           For all its pitfalls, I like technology.  (How else will we achieve greater productivity?  Plainly put, we can work longer and harder, or we can make machines that will work faster and smarter.)      

      I like financial services.  (No nation, company, or individual can move forward without insurance to protect against unforeseen catastrophe; without a banking system they can trust not to lose their money or abscond with it; and financial managers to help manage their newly-acquired assets.)       

           I am humbled every day by the collective wisdom and idiocy of the market and it's players, ever stunned by the excesses and occasional successes I see, and ever fascinated by the extraordinary popular delusions and madness of the crowds.  This leaves me just enough arrogance to believe that common sense is the touchstone we must aspire to.  Common sense means taking advantage of the public’s propensity to panic out of, then embrace, health care, technology, financial services, Asia, and energy for at least the next major cycle.  I'll be there buying with both hands when my favored industries are weak, as energy was not too long ago and as health care is today, and I'll be there selling when the crowd is clamoring to get in at any price.
       After, and only after, I have selected the primary asset allocation sectors and industries, do I ask myself, "Will US companies or foreign firms be most likely to succeed in this endeavor?  Will small-cap hares do best in this environment (they usually do best after a big scare when large-cap tortoises are pulling their heads and legs back into their shell) or have they had their day and now the large-caps are forging ahead because of all their R&D money, marketing muscle, and more seasoned management?  Should I buy 100% equities for maximum gain or is the risk high enough that I should buy convertible bonds or preferreds, or even some straight income selections, in my chosen industries?       

           It is the willingness to apply common sense, the ability to define the demo-trends that are clearly ascendant, and the courage to allocate cash assets when the chosen sectors are depressed, then sell when at the top of one of the cyclical zeniths - in preparation for the next buying opportunity in the then-most-favorable sectors - that makes our brand of asset allocation more successful than merely mechanical 60/40 or 70/30 "rules".       

           I believe the timing is propitious now to be acquiring the best sectors.  Over the next couple days, I don’t have a clue where the market will go.  (Neither does anyone else but that doesn’t stop hundreds of charlatans from selling advice to millions of hopeful fools who try to time the market day-to-day.)  Over the next few months, it may be bumpy.  But over the next few years, I believe the trend will go only one direction -- up.  My goal is not to time the market with bad selections but to focus on building a portfolio of intense value.  I do that with intelligent asset allocation.
       I can clearly define how I’d like to allocate our assets.  That just leaves stock selection.  Too many investors (and, regrettably, advisors) spend 100% of their time here.  They neglect to do their homework on where they are in the cycle, they overlook the basic research needed to determine the demo-trends that should guide their asset allocation decisions -- the most important step and the one that can overcome so-so market timing -- and spend all their time chasing the latest tip, rumor, or chat room favorite.       

           My desk may be disorganized (OK, my desk is disorganized!) but my mind is clear and focused because asset allocation guides my stock selection.  For our best ideas in terms of which stocks in our favorite sectors are priced to move ahead, please see our model portfolios and the new ideas on the next couple pages...   <  >

           Contrary to what some US textbooks might have you believe, oil was not discovered by “Colonel” Edwin Drake in 1859, though he was a key player in the evolution of oil drilling.  We’ve used oil for centuries.  Oil wells were drilled in China, at depths of up to 800 feet, using hard bits attached to bamboo poles, for at least a couple centuries prior to the birth of Christ.  Over the next couple thousand years, cultures all over the world collected seep oil (oil that oozed out of the earth at various points in the surface) to light their street lamps and more.   

           Marco Polo recorded his observations in 1264 in what is now Baku, Azerbaijan: "..on the confines toward Geirgine there is a fountain from which oil springs in great abundance, inasmuch as a hundred shiploads might be taken from it at one time."  In 1264, Europeans and Asians knew about oil.  So did American Indians, who collected it in seeps all across the country.  Lest we think this industry is a fledgling, even the “new” technology of separating oil from oil sands was done as long ago as 1735 in France.       

           Just before the American civil war, a Canadian geologist figured out how to distill kerosene from oil, thereby saving the world’s whales.  That’s right.  The next time some eco-Nazi tries to tell you you’re an evil person for using electricity, remind them that, prior to the 1800s, light was provided by torches, tallow candles, and foul-smelling lamps that burned animal fat. In the early and mid-1800s, whale oil, with less odor and smoke than most fuels, became the fuel of choice.   A powerful whaling industry developed to provide whale oil for lighting and lubricants for the machinery in factories and trains.  Some species were driven to the brink of extinction. The right whale was killed in the early 1800s at a rate of about 15,000 per year.       

           When a truly clean-burning kerosene lamp -- the first mass use of fossil fuels in America -- hit the market in 1857, its effect on the whaling industry was devastating. Kerosene (known then as coal oil) was cheap, abundant, smelled better, and didn’t spoil like whale oil did. The public abandoned whale oil lamps overnight.  If petroleum products, such as kerosene and machine oil, had not appeared in the 1850s as alternatives to whale oil, many species of whales would have disappeared long ago.        

           Call it what you will — black gold, Texas tea, dead dinosaurs, or whatever — “oil” means more than just “oil”.  Over millions of years, various decaying biomass turned into coal, oil, or natural gas.  At Investor’s Edge, we do not use the three terms interchangeably.  There are times when we want to be buyers of coal, other times natural gas, and other times oil.  Sometimes we want to own all three.  And for the very long term (generations, not years) we want to always own at least some of each, as well as alternative energy companies in the solar, wind, biomass, and fuel cell areas.  We refer to “energy” companies, not oil companies, when we label companies that seek to find, extract, refine, and distribute any of these fuel sources.
    What should you do now? Buy energy companies.  Buy them when the rest of the investing community is uninterested.  If there is one slam-dunk demographic trend I can depend upon, it is that more people will use more energy to do more things and go more places.  In our portfolios we already own BAKER HUGHES (BHI), BHP BILLITON (BHP), BP (BP), DEVON ENERGY (DVN), EXXON (XOM), SHELL (SC), CHESAPEAKE (CHK), COMSTOCK (CRK), TEPPCO (TPP) and WESTMORELAND COAL (WLB pr).  Now I want you to buy (cont’d on page 4)  < >

HEADLINE ARTICLES 

2004