The Sunday Times, Sunday 6th July, 2008

MONEY MATTERS

Small Change

Look at the big picture to reap higher returns

If you look past economic woes, you'll find the slump in equities offers good buying opportunities.

By JOSEPH CHONG

Recently, Prime Minister Lee Hsien Loong made a speech about LUV.
He wasn't talking about romance but mulling over the economic downturn in the United States, the graphical 'shape' of the recovery and the impact that it will have on the Singapore economy.

He said that the US recovery could be shaped like an L (slow for a very long time), a U (slow for some time) or a V (quick rebound).

LUV aside, it is crucial to understand the big picture if you want to make successful investments. For those wondering what investing stance to take, the big picture is that the US economy will recover sooner or later.

The problems with residential overbuilding and overlending in the US are being fixed through a sharp fall in real estate prices. Indeed, the fall in property prices is now attracting overseas investors to the US, and their investments will eventually seed a sustainable recovery.

One investor who sees the big picture is the highly respected Warren Buffett. Despite his folksy manner, he has a deep understanding of big-picture trends, which are the key to his investing methods.

A current example of this big-picture view is that he believes the US housing market will eventually recover because of demographic trends.

Mr Buffett's investing strategy can be copied by individual investors.
Most of his long-term holdings are not in companies with spectacular revenue growth, but in very profitable ones with low capital expenditure needs.
They have strong brands and thus are not subject to severe price erosion, for example, Coca-Cola and See's Candy.

These long-term holdings generate excess cash and dividends regularly. This steady cash stream allows Mr Buffett to exploit investment opportunities as they arise, such as those presented by the currently cheap markets.

Another big-picture issue that troubles Singaporeans currently is the level of inflation, especially for food and energy.

High food costs can be traced to the misguided rush by governments to substitute oil with biofuels. The right response would have been to encourage conservation while diversifying away from fossil fuels.

Notwithstanding the current high inflation rate of 6 per cent, the trillion-dollar global bond markets are signalling that this is temporary in nature and that inflation will fall back. This is because inflation-indexed bonds worldwide are flagging inflation of 2 to 2.5 per cent over the next 10 years.

So, are bond investors wide-eyed, irrational optimists?
The crux of the big picture is that mankind does not have an energy shortage. There is an oil shortage because people have have chosen foolishly to rely on oil for so much of their needs.

Energy is actually 'free' as all of it comes from the sun, directly or indirectly. Even oil is solar energy re-released from buried and decayed plants and animals. Cover 1 per cent of the Sahara Desert with solar panels and all of the world's energy needs could be met.

Breakthrough advances in thin-film solar panels are now making it commercially viable to harness this 'free' energy, and business is booming for solar companies. Maybe that's why traditional oil companies such as BP are valued at only 10 times their net earnings, while solar energy firms are priced at 100 times net gains.

Another big-picture solution is nuclear energy. Hang-ups about its safety and about weapons abuse have deprived the world of an energy source that could last mankind millions of years.

This short-term pain of high energy prices is unfortunately necessary to force a switch to other, more efficient and cleaner energy forms.

I agree with the bond market that high energy prices are temporary - eventually, oil will go the way of coal. I would not be surprised to see the price go back to US$50 a barrel within the next 10 years.

Individuals can work around this transitory pain and perhaps exploit it as investors.
Daily conservation opportunities can be found everywhere.

For example: If you need to drive, consider hybrids or alternative fuel vehicles. My hybrid gives me about 50 per cent more mileage. This - with other tax and time savings (no need to fill up so often) - will deliver overall savings of about $12,000 over the 10-year life of the car, and that's a conservative estimate.

For individual investors, I'd agree with Mr Buffett that the current weak equity market represents an investing opportunity.

The annualised 10-year rate of return for equities worldwide has fallen off the cliff, diving to merely 5.1 per cent as at June 4, as stocks have been sold down. Equities are now valued at only 11 times earnings, compared with the historical average of 15 to 16 times. This is near an all-time low worldwide, despite sound economic fundamentals, if you exclude the US.

Theoretically, returns on global equities must track dividend yields plus nominal world economic growth, which together have exceeded 9 per cent in the past 10 years.

I believe that returns will climb back to the historical average eventually, but the timing is uncertain. The current annualised 10-year yield corresponds to world economic growth of about 0 to 1 per cent permanently.

Unless one believes that the world economy is about to fall into a permanent state of near recession, returns must correct upwards. Should average annual returns climb back to 9 per cent, this would imply a rise of more than 40 per cent in global equity markets.

Maybe this is what Mr Buffett sees because he has been actively buying around the world recently.
 

.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions