Coke break

One thing I got out of the book I read on John Templeton was a sense of how he got into hated stocks and held his nerve.

Buying the airlines after 9/11 was an example – he knew they were despised, he didn’t believe it was the end of travel, and he was convinced that the government would not let them go bust in the wake of a terrorist attack – that would mean that the terrorists had won. It was also clear that once he made the decision, he could stomach a lot of volatility on the way to making money.

So it wasn’t enough for something to be cheap but shunned. He needed an angle.

And there is no doubt that, if you’re out to buy consumer discretionary stocks or financials right now, you need some kind of angle. Last Tuesday was a great time to buy consumer discretionary and distressed financials just because they were hated. Short interest in individual US financial names, at 11% was more than three times the short interest in tech names in 2001 & 2002. And I’m sure the long onlys were one way only.

But if you bought then because everyone hated them, you might have sold yesterday on the US correction, or today on the National Australia Bank announcement. NAB didn’t just chuck out the kitchen sink – it tossed the whole kitchen.

So this is where the ‘angle’ comes in. And getting the angle is, I think, the difference between fast money trades and quick profits (and I’m not knocking quick profits) – and serious compounding returns. My view is that ‘the angle’ makes you three or four times the returns you get on correctly timing a quick sentiment call.

And the angle here is falling inflation. Now that’s a big change from the world as we know it. Ever since early 2002 we’ve seen building inflationary pressure and rising resource prices. Believe it or not, 97 of the 100 commodities that make up the broad Goldman Sachs commodities index were up in 2002. That was one thing that told you, before the equity rally from March 2003, that the world economy might be on its way back up.

It’s quite hard to back up the truck from the kind of inflationary pressure that we’ve seen build over the past five years. What with concatenating resource and infrastructure shortages and with powerful wage pressure in the oil producers and the currency manipulators. There’s an awful lot of evidence out there that inflationary forces are strong.

But that’s the point. You get the biggest payoff from an anti-inflation call when there’s lots of inflation, but the pressure is turning.

And turning it is. First off, the Fed is holding money tight – we’re seeing very little base money growth in the US – despite all the talk of ‘printing money to bail out Bear Stearns’ etc. Next we have the aggressive shrinking of the US non-oil current account deficit – that effectively reduces bank deposits in the rest of the world. Then we have the massive unwinding of the bank multiplier – as the shadow banking system folds in on itself. It all leads to a major reversal in global bank reserve accumulation.

All this is generating deflationary pressure across the world. And from a point of maximum tightness, we likely see logistical and resource bottlenecks loosen across the world. We also see a reversal of the incentives to hoard resources. We may well get Europe, the UK, Australia and New Zealand in recession in 1H09, a dip to lower growth in the US and a collapse in Eastern Europe.

Now, if I’m right, and this causes a major fall in energy, food and metals prices, we’ll start to see a powerful play-through to headline inflation. Even if oil just stopped going up, US headline inflation would fall back from 6% to 3% by next June. If oil falls back sharply, we could get a zero headline CPI reading, even negative numbers.

1975 can tell you a lot about how markets behave when inflation falls fast – and thanks to Teun Draaisma of Morgan Stanley for the data on this. Because headline inflation is the single most powerful driver of PE ratings (see chart). In a period of high and rising inflation, ratings get crushed – as they should. Because no one knows their cost of capital, and there are huge incentives to run companies inefficiently (ie with high inventories). That’s why, when you see inflation coming to a sector’s prices – always buy the small inefficient companies. That worked for housebuilders in 2000, and it worked for miners in 2003.


But when inflation falls, it’s a different story. Teun points out that US EPS fell 40% from December 1974 to April 1976. A disaster story – and the expectation of falling earnings is something many people are using to remain bearish now. They may be right, on the outlook for earnings that is. But inflation fell from 12% to 6% through 1975 as food and fuel prices fell-off. And the market was up 80% over the period. It was re-rating a-go-go.

So what should an investor do, if he thinks we are due an inflation break? The first thing he should do is sell all the small stocks in the inflationary sectors. Small cap oil and junior miners are toxic in a world like this.

The second thing he should do is buy big and low cost. Big sales to market cap, big economies of scale, lowest costs in the business. Companies that win with scale. In Asia it is stocks like Tsingtao Breweries and China Mobile. In the US it’s the Cokes and Walmarts. GM doesn’t win on costs, but it hits the ball out the park on sales to market cap.