One of the great pleasures of value investing is discovering another like-minded value investor with interesting views. US fund manager Smead Capital Management was founded in 2007 and its June quarterly update discussed the 'Well known fact':
A journalist from Fortune magazine once asked Andy Grove, the former CEO of Intel, for the best business advice he'd ever been given. Grove provided a simple quote from a former professor at City College of New York: “When everybody knows that something is so, it means that nobody knows nothin.”
In other words, business people and investors become “hopelessly devoted” to a vision of the future, which is erroneous from an investment standpoint. This strikes at the heart of a concept that we at Smead Capital Management call “The Well Known Fact”.
We define a “well known fact” as a body of economic information which is not only known to all market participants, but has been acted upon by anyone in the marketplace who wishes to participate. The best way to understand the concept is to show past well known facts:
1. The well-known fact in 1929 was that the invention of the automobile, airplane and radio were going to spur a “permanently higher plateau” in US equity prices.
2. The well-known fact in 1981 was that inflation was going to cause interest rates up to 20% on long-term Treasury bonds and a 25% prime rate for bank top customers. Also, the only investments which could fare well going forward were those which benefited from high rates of inflation. Long-term bond investing and blue chip stock investing were considered a fool's game.
3. The well-known fact in 1990 was that emerging market sovereign debt from countries like Brazil was going to bankrupt a major money center bank. Also, the S&L debacle of the late 1980's was going to ruin the US economy.
4. The well-known fact of 1999 was that “the internet was going to change our lives”. Also in 1999, the fact was that it didn't make any difference what you paid to buy the most successful tech companies of that era.
5. The well-known fact of 2005 was that we never have a nationwide sell-off in housing.
6. The well-known fact of early 2009 was that we were embarking on “seven lean years and a new normal” for the US economy.
You can read the quarterly here, but given how poorly investors that invested based on these well known facts fared Smead appropriately asks what is today's well known fact.
If you've been following Intelligent Investor Share Advisor's advice over the past couple of years then you might already know the answer. Smead continues:
The well known, fact, as we see it, is that a huge pool of new middle class citizens in emerging market countries are being added to the worldwide population of middle class consumers in the developed economies. These additional emerging market country consumers will want all the things that US consumers have wanted, from beef steaks to fashion clothing to automobiles.
This well known fact seems to be driven by the uninterrupted growth in China and the relatively uninterrupted growth in the countries like Indonesia, Singapore, Malaysia, Vietnam, Australia, Canada, Russia and Brazil, which have benefited the most from China's boom.
Smead's conclusion for your portfolio is clear:
We believe you are “out of your head” if you stay in love with the well known fact and stay invested in emerging markets, gold/oil /commodities, multi-national consumer staple companies, energy, basic materials, international heavy industrial companies, and the sovereign debt and stock markets of commodity export nations like Australia, Canada, Brazil and Russia.
We have learned that history shows that even if the fact ends up being correct, you lose and history says lose bigger! Warren Buffett says, “What the wise man does at the beginning, the fool does at the end.” Every asset class we've mentioned in this paragraph was a great idea in 1999. Oil was $11 per barrel, gold was at $250 per ounce and central banks around the world were selling it, and American investors had almost zero participation in emerging markets.
In the same way that no one rings a bell at the top of the market, except for a handful of contrarian investors like Warren Buffett and Jeremy Grantham (and Share Advisor) few were publically recommending buying stocks at the nadir in 2009. But following a few simple rules can compound your returns at rates that dwarf the major indexes.
Buffett's quote to 'Be fearful when others are greedy and greedy when others are fearful' is timeless, but avoiding obvious risks such as the 'Well known fact' is crucial.
Investors have been selling resources and mining and engineering services stocks across the board, but as mining investment eventually falls from 8% of GDP back toward the long-term average of 2% (or below) it's hard to imagine that higher unemployment and lower wages won't eventually have an impact on the banking sector where valuations and prices are currently approaching record highs, for example. We currently have a tiny allocation to banks in our model Income portfolio, but others have huge exposures as it's a 'Well known fact' that the banks have a tiny direct exposure to the resources sector who borrow money elsewhere. In this example, it's the second round effect of falling profits in the resources sector that intelligent investors are thinking about.
Only those that build arks survive a flood, and with market volatility and credit spreads approaching multi-year lows and plenty of liquidity in the system, now is the time to insure your portfolio and protect the hard won gains since the GFC. There's no point waiting for bad news in the headlines to act.
For Bill Smead's view on China, and why you never see economists on the Forbes or BRW rich list, check out this recent interview on a local edition of CNBC.