How To Diversify Investments During Time Of Crisis

AS a result of the financial crisis, even though most commodities have not been performing well, gold has outperformed the conventional asset classes like equity and bond.

This has prompted some investors to consider commodities as one of their investment asset classes. In this article, we will look into how to invest in commodities.

Bruno H. Solnik and Dennis W. McLeavey in their book titled “International Investments” classified commodities in three major categories – agricultural products, energy and metals.

Examples of agricultural products are fibres (wood, cotton), grains (wheat, corn, soybean), food (coffee, cocoa, orange juice) and livestock (cattle, hogs, pork bellies). Energy products can be crude oil, heating oil and natural gas whereas examples of metal products are copper, aluminum, gold, silver and platinum.

The main reason behind investing in commodities is that they have negative correlation with stock and bond returns. This will provide a good way to diversify portfolio risks. Besides, given that commodities are positively co-related to inflation, they can help investors hedge against inflation.

Investors can consider investing directly in commodities or indirectly by buying into futures contracts, bonds indexed on some commodity price as well as stocks of commodity related companies.

Some companies will invest in commodities that are extensively used as raw materials in their production processes. High commodity prices or raw material prices will affect those companies’ performance. However, if they have invested in their raw materials, even though their profitability might be affected by high raw material prices, the gains from their investment in those commodities will offset the losses in their operations.

Some investors will consider buying into commodity futures, such as crude palm oil (CPO) futures as this is one of the easiest and cheapest ways to get exposure to commodities.

However, investors need to understand that futures trading requires a high level of trading skills as most commodity players are well-equipped with the required market information, like total world supply and demand of CPO as well as the weather conditions in those producing countries.

Some financial institutions may offer unit trust funds that invest directly in those commodities or indirectly through buying into commodity futures. In the United States, investors can buy into commodities via exchange traded funds (ETF) that are invested in commodities futures.

An ETF is a special type of fund that tracks some market indices and it is traded on a stock market like any common share. Given that the world economy may recover further and oil prices may go beyond US$100 per barrel again, buying into oil or other commodity related ETFs may provide retail investors an alternative to get exposure into commodities.

Since commodity cycles and the general business and stock market cycles are usually different, investing in commodities provides a good way of portfolio diversification.

Besides, investors can consider buying into collateralised futures funds (sometimes they are referred as structured products). A collateralised futures fund is a portfolio that takes a small long position in commodity futures and invests the rest of the money in government securities. Normally, it is capital guaranteed as the yield generated by government securities will be used to cover for the cost incurred for the futures contracts.

Lastly, investors can consider buying into listed companies that are commodity related. In Malaysia, if investors wish to gain from higher CPO prices, they can consider buying into plantation companies.

Given the current gold prices of more than US$1,150 per ounce, some investors are eager to know whether there are any further upsides to the gold prices. Some analysts and fund managers have predicted that the gold prices may go beyond US$1,200 to US$1,300 per ounce.

Investors will rush into gold during a financial crisis, like the current financial crunch and the Great Depression in 1929-32, because gold can keep its value during those periods.

We believe that gold is a cyclical product. Even though nobody knows how high the gold prices can go, given that the world economy is showing signs of recovery, the upside potential for gold investing may be limited.

Can Stock Market Rally Last?

NEW YORK: Somebody on a bus asks a friend, "How about that stock market?"

The response: "Unbelievable." Caribbean vacationers lounging poolside check their Blackberries for stock prices.

Suburban gym members chat about the latest market gains during their morning workouts.

Welcome to the 2009 bull market - or so many people think.

They're buying up shares of everything from Google Inc. to Bank of America Corp. at a pace not seen since the 1930s.

Since March, the Dow Jones industrial average has jumped 57 percent and the Standard & Poor's 500 index has gained 62 percent.

Investors are betting on a strong economic recovery. But here's the problem: Good news ahead could be bad news for the bull.

To understand why, consider the very thing that has boosted the market.

The U.S. government has spent nearly $1 trillion to stimulate the economy and the Federal Reserve has maintained a policy of keeping interest rates near zero.

Those will disappear as the economy's health improves, potentially halting the bull market by taking away what has been its crutch - sources of cheap and plentiful money.

"Pretty soon the easy money phase could be behind us," said Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors, an investment firm in Albany, New York.

The government has plunged big money into the marketplace, through tax cuts,
construction projects and other measures. At the same time, low interest rates have invigorated stocks by reducing borrowing costs and bolstering corporate profits.

The low rates have also knocked down the returns of other short-term investments, like government bonds and money-market funds.

Since people aren't getting high returns on those investments, they're buying stocks.
Stocks are risky because they don't guarantee a return, and the recent bear market shows how deeply share prices can drop.

From October 2007 through March, the Dow industrials lost 53 percent.

"The Fed is forcing everyone to take risk by buying stocks because if you don't take risk, you will be earning nothing on your money," said Ed Yardeni, president and chief investment strategist at Yardeni Research.

Yardeni said his clients, which include pension funds and institutional investors, feel like they don't have a choice but to buy stocks right now.

He sees lots of "fully invested bears" - investors who don't believe that investing in stocks makes sense right now because of the state of the economy, but they are buying anyway because they worry they might miss out on a bull run.

The Dow is trading above 10,000 for the first time since October 2008, though it is still 27 percent below its peak two years ago.

The S&P 500 has gone up almost 7 percent just this month.

Plenty of investors and analysts don't see an end to those gains, especially if the economy picks up in the coming months.

But a strong economy is just what Yardeni and some others on Wall Street say could thwart the rally should it lead to higher interest rates and waning government stimulus.

The Fed isn't expected to act soon.

The U.S. central bank has kept the target range for its bank lending rate at zero to 0.25 percent since December.

It pledged this month to keep that rate at a record low for an "extended period."

How long that really means is anyone's guess.

The Fed said in a statement after its November meeting that economic activity has "continued to pick up" and that the housing market has strengthened - a key ingredient for a sustained recovery.

But a 10.2 percent unemployment rate and weak consumer spending is still plenty worrisome to the economy's overall health.

Yardeni thinks once the Fed even begins to hint of looming changes in its interest-rate policy it will "take the steam out of this rally," he said.

"It won't take much to push this market back down."

In the past, higher rates didn't knock down stocks immediately.

The Fed cut its benchmark rate from 2001 through 2003 to stimulate growth, taking it down to a low of 1 percent, where it stayed for a year.

The low rates reduced mortgage costs, feeding the housing boom, and sparked a bull market in stocks.

The Fed started to slowly raise rates in July 2004 to slow the economy and keep inflation in check.

The housing market peaked in 2006 and the stock market followed in 2007.

After that, both headed into a free fall.

Back in 1982, a sustained bull market began amid a deep recession, and the gains lasted even though the Fed began to boost rates.

There was more to lure investors back to stocks then, notes David Rosenberg, chief economist and strategist at Canadian wealth management Gluskin Sheff.

Stock dividend yields were 6 percent then; today they are below 2 percent.

That means investors had a greater potential to generate income off their stock investments, regardless of whether prices rose or fell.

Bond yields were at double-digits and were expected to fall in 1982; today short-term bonds pay nearing nothing and yields will likely head higher.

That could make fixed-income investments more attractive.

Investors still should heed the potential danger signs of today's market, before their exuberance gets the better of them. - AP

Think Like Warren Buffett

1. Think of Stocks as a Business

Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions.

That's why Buffett has stated he believes stockholders should think of themselves as "part owners" of the business in which they are investing. By thinking that way, both Hagstrom and Buffett argue that investors will tend to avoid making off-the-cuff investment decisions, and become more focused on the longer term. Furthermore, longer-term "owners" also tend to analyze situations in greater detail and then put a great eal of thought into buy and sell decisions. Hagstrom says this increased thought and analysis tends to lead to improved investment returns.

2. Increase the Size of Your Investment

While it rarely - if ever - makes sense for investors to "put all of their eggs in one basket," putting all your eggs in too many baskets may not be a good thing either. Buffett contends that over-diversification can hamper returns as much as a lack of diversification. That's why he doesn't invest in mutual funds. It's also why he prefers to make significant investments in just a handful of companies.

Buffett is a firm believer that an investor must first do his or her homework before investing in any security. But after that due diligence process is completed, an investor should feel comfortable enough to dedicate a sizable portion of assets to that stock. They should also feel comfortable in winnowing down their overall investment portfolio to a handful of good companies with excellent growth prospects.

Buffett's stance on taking time to properly allocate your funds is furthered with his comment that it's not just about the best company, but how you feel about the company. If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?

3. Reduce Portfolio Turnover

Rapidly trading in and out of stocks can potentially make an individual a lot of money, but according to Buffett this trader is actually hampering his or her investment returns. That's because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.

The "Oracle" contends that what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.

Investors must think long term. By having that mindset, they can avoid paying huge commission fees and lofty short-term capital gains taxes. They'll also be more apt to ride out any short-term fluctuations in the business, and to ultimately reap the rewards of increased earnings and/or dividends over time.

4. Develop Alternative Benchmarks

While stock prices may be the ultimate barometer of the success or failure of a given investment choice, Buffett does not focus on this metric. Instead, he analyzes and pores over the underlying economics of a given business or group of businesses. If a company is doing what it takes to grow itself on a profitable basis, then the share price will ultimately take care of itself.

Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that.

5. Learn to Think in Probabilities

Bridge is a card game in which the most successful players are able to judge mathematical probabilities to beat their opponents. Perhaps not surprisingly, Buffett loves and actively plays the game, and he takes the strategies beyond the game into the investing world.

Buffett suggests that investors focus on the economics of the companies they own (in other words the underlying businesses), and then try to weigh the probability that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. He adds that by focusing on the economic aspect of the equation and not the stock price, an investor will be more accurate in his or her ability to judge probability.

Thinking in probabilities has its advantages. For example, an investor that ponders the probability that a company will report a certain rate of earnings growth over a period of five or 10 years is much more apt to ride out short-term fluctuations in the share price. By extension, this means that his investment returns are likely to be superior and that he will also realize fewer transaction and/or capital gains costs.

6. Recognize the Psychological Aspects of Investing

Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking.

More than anything, investors' own emotions can be their worst enemy. Buffett contends that the key to overcoming emotions is being able to "retain your belief in the real fundamentals of the business and to not get too concerned about the stock market.

"Investors should realize that there is a certain psychological mindset that they should have if they want to be successful and try to implement that mindset.

7. Ignore Market Forecasts

There is an old saying that the Dow "climbs a wall of worry". In other words, in spite of the negativity in the marketplace, and those who perpetually contend that a recession is "just around the corner", the markets have fared quite well over time. Therefore, doomsayers should be ignored.

On the other side of the coin, there are just as many eternal optimists who argue that the stock market is headed perpetually higher. These should be ignored as well.

In all this confusion, Buffett suggests that investors should focus their efforts of isolating and investing in shares that are not currently being accurately valued by the market. The logic here is that as the stock market begins to realize the company's intrinsic value(through higher prices and greater demand), the investor will stand to make a lot of money.

8. Wait for the Fat Pitch

Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player.

Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.

Bottom Line

"The Warren Buffett Portfolio" is a timeless book that offers valuable insight into the psychological mindset of the legendary investor Warren Buffett. Of course, if learning how to invest like Warren Buffett were as easy as reading a book, everyone would be rich! But if you take that time and effort to implement some of Buffett's proven strategies, you could be on your way to better stock selection and greater returns.

How To Handle Market Uncertainty

AFTER the strong rally over the past seven months, the market is finally undertaking some corrections. Some investors may not fully comprehend why the stock market moved up when the companies reported bad financial results, but tumbled when the companies started to show better financial performance.

We need to understand that the market had discounted the good news. Some of those good financial results were already reflected in the stock prices. The stock market cycle always moves ahead of the economic cycle.

During the Great Depression in 1929, the stock market recovered eight months ahead of the real economic recovery. Even though some investment experts say the worst is far from over, we notice that a lot of economic indicators are pointing to an economic recovery.

However, the economic growth may not move as fast as the stock market. As a result, while the economy continues to recover, stock prices need to come down to reflect the fundamentals of the companies.

This explains why once investors started to realise that the stock prices could not be supported by the fundamentals of some companies, especially blue-chip stocks, the stock prices had to come down to reflect the true value of companies.

Nevertheless, based on our analysis, most listed companies in Malaysia showed great recovery in their second quarter of 2009 financial results against the results in the first quarter as well as the fourth quarter of 2008.

We need to understand that there are many disturbing factors that affect the stock prices, but not reflect the fundamentals of companies. From the perspective of behavioural finance, investors’ expectations and emotions have great influence on stock prices. Two factors influence investors’ expectations – past experience and new information.

In the absence of new information, investors will use past trends to extrapolate into the future. As a result, the stock prices may persist in trend for a while before the next market reversal.

This may cause the market to overreact to good financial results as shown by some companies.
According to Fischer Black, some investors tend to be affected by noise that makes it difficult for them to act rationally. He defines noise as what makes our observations imperfect as well as keeps us from knowing the expected return on a stock.

Some investors, due to lack of self control and proper financial training, may misinterpret economic information and sometimes be carried away by the stock market emotion. Investors may feel uneasy over the recent strong market performance. However, they will still choose to follow the market trend even though they feel their judgment may be wrong. In behavioural finance, we label this as conformity in which we are inclined to follow the example of others even though we do not believe in the action.

The above phenomenon of stock prices being valued beyond the fundamentals of the companies is applicable to some selected blue-chip stocks. Nevertheless, Bursa Malaysia does have plenty of second- and third-liner stocks which are still selling at cheap valuations. Investors may want to take the current market corrections to accumulate them for the long-term.

We need to relate the current stock prices to the intrinsic value of the companies. Some investment tools like price-to-earnings ratio, dividend yield and price-to-book ratio will assist us in filtering out some good companies for investment.

Even though there are a lot of uncertainties along the way to full financial recovery, we feel that investors may view the recent corrections as good opportunities to build their long-term investment portfolios. For those who have been looking for investment returns higher than fixed deposit rates, there are still a lot of stocks that are paying handsome dividend yield of more than 4% and yet selling at cheap prices.

One of the most important investing principles is to have the discipline to hold long term. We should not pay too much attention to the fluctuation of stock prices; instead, we need to focus on the earning power of the companies as it is one of the most important drivers in deriving the intrinsic value of a company.

As a result of the financial crisis, even though a lot of companies are showing great recovery, their performance and prices are still lower than their peak level during the year in 2007. If the overall economy and the companies’ performance recover to 2007 level, their current stock prices may be a good entry level.

Are The Markets Overvalued?

GLOBAL stock markets have recovered sharply from their bottom in March 2009. Where will our markets go from here?

To answer this question, we have to consider the prospects of the US market as the correlation between the US and world stock markets is very high especially when major movements occur in the US stock market.

In fact, emerging markets normally exhibit higher beta, moving up more than the US markets in a recovery and falling by more in a downturn.

The price-earnings ratio (PER) of the US market has ranged from a recent low of 6.6 times during the deep recession in July 1982 to over 40 times during the tech bubble in 1999.

The PER of the US market (as measured by the Standard & Poor’s 500 Index) was 22 times when the Dow peaked at 14,164.5 points on Oct 9, 2007, compared with an average 14.6 times from 1895 to 1995, according to Professor J Shiller (see chart).

Shiller’s data also shows that for that period, the market traded between 10 and 20 times earnings for 70% of the time.

According to consensus forecast, the S&P 500 which comprise 500 of the larger stocks in the US (rather than just 30 stocks for the Dow) is trading on a current PER of around 20 times, implying that the market is trading at close to the upper end of its normal trading range.

Does this imply an imminent correction?

The PER of the market cannot be viewed in isolation. Other factors like interest rates, inflation rates, earnings growth and human psychology have to be considered.

Market PERs are normally higher when inflation and interest rates are low.

Low deposit rates will make stocks more attractive as dividend yields of stocks could be higher than deposit rates; and stocks, if chosen well, could provide earnings growth which could boost future dividends.

The PER of the stock market was below 10 times in the early 1980s when inflation and interest rates were high.

The then Fed chairman Paul Volcker, who successfully tamed inflation with a tight monetary policy in the early 1980s, set the stage for falling interest rates and one of the longest bull run from 1982 until the bursting of the tech bubble in early 2000.

With the Fed slashing interest rates to almost zero following the global crisis precipitated by the collapse of Lehman in September 2008, the attractiveness of equities has improved versus bank deposits which pay pitiful interest rates.

Third quarter earnings of US companies have generally outperformed analysts’ forecast with 79% of the S&P 500 companies posting results that exceeded estimates.

Revenues have been lacklustre and earnings have been achieved in part from cost cutting and from a weaker US dollar which has boosted revenues for US multinationals.

More than half of the earnings of US multinationals are denominated in foreign currencies which have appreciated against the US dollar.

The Japanese market peaked at almost 39,000 in 1989 and was then trading on a PE of over 70 times.

Such high PERS cannot be justified or sustained for long and the Japanese market is currently trading at less than a third of its peak value.

The difference between the US and Japanese stock markets is that the US markets were less overvalued when the economic and stock market crash happened in September 2008.

The Dow has surpassed 10,000 points and has recovered almost 50% of the 7,617 points it lost between the peak of 14,164.5 points on Sept 10, 2007 and the bottom at 6,547.1 points on March 9, 2009.

Economic recovery remains weak and hence the excess liquidity resulting from lower interest rates and printing money is finding its way into financial markets (especially stocks and commodities) and properties.

A double dip into a deep recession is unlikely as house prices in US and many other countries have started to recover thereby boosting consumer confidence and bank profits through write-backs and higher valuation of mortgage-backed securities.

A more likely scenario is a lacklustre recovery, dampened by weak consumer spending as US consumers deleverage.

At these levels, the US markets seem to be fairly valued.

Any significant move up may push the US markets into bubble territory, a possibility that cannot be ruled out as central banks and pump-priming politicians are only likely to act when the bubble is obvious.

After all, who wants to spoil a good time that wins votes.

At these levels, investors will have to be more cautious.

Stocks with a high dividend yields that can be sustained offer some protection as investors are seeking yields in a low interest environment.

This would include the utility, telecommunication and food sectors.

The gaming, tobacco and alcoholic beverage sectors should also see stable demand, that is if they are not subject to large excise duty or tax increases in the budget.

Those seeking growth should ensure that the companies’ PER are reasonable and growth can be sustained in a competitive environment where excess capacity may encourage price dumping.

The rubber glove companies in Malaysia have pricing power as they produce 60% of the world’s rubber gloves and sell to the healthcare industry where demand is steadily growing.