A Letter To A Bearish Client

Mike*, our foundation client and a dear friend, sent us a really bearish broker note as if John Hempton – a shortseller by inclination – needed to get more bearish. He was adjusting his portfolio accordingly. We won’t be.

Here – with a few corrections and expansions – is my reply:

Dear Mike

The bear case always sounds intellectually more convincing than the bull case. And it is in this broker note too. Intellectual sounding and convincing.

But America is still an amazingly innovative country, humans are ingenious and most of the imbalances will sort themselves out. Big cap equities are cheap relative to almost all other assets (especially relative to small cap equities, cash and bonds and to many assets such as commercial property that require leverage). Cash yields almost minus 3 per cent after inflation and less post tax. Bonds are scary as hell and yield minus 1% after tax and inflation.

Big though difficult-to-run companies are at low teens multiples.  Great franchises are at mid-teens multiples.  Tesco (UK) which is a truly great franchise – is at a 14 PE ratio. And the Pound is historically cheap. WalMart and Target – both slightly less good franchises – are at 12 times. The difficult parts of Silicon Valley (eg HP) are well under 10 times PE ratios (and we feel no need to own that one). The less difficult parts of Silicon Valley (Google for instance) are at a high teens PE ratio once you take out the excess cash. We own that.

Own equities.  Don’t kid yourself.  Mega-cap equities are generationally cheap compared to other assets – and certainly compared to the cash/bond/levered asset complex.

Just don’t be blind about it. The places that there have been high returns (Asia, small caps, smaller resource companies) are riddled with fraud. 20 five years of deregulation and the high levels of innovation mean we have high and rising levels of stock fraud. Fortunately there is much less fraud risk in mega-caps.

Don’t own Australia or the iron-ore-coal-steel complex. It has run too far and has been too easy to make money. Too many stupid/aggressive/greedy people are doing too much expansion. Some of these people are stupid – but they have made much more money than you or me so they must be right!

I can find dozens of reasons to be bearish – but I look at it dispassionately and I am bullish on big caps, and bullish on America. The problems will sort themselves out and the American exceptionalism (decent institutions, free enough markets and a willingness to take risks) will work their magic again.

Anything that takes you out of real assets (businesses and property that generate real cash flow) and puts you into nominal assets is – with a 10 year time-frame – a bad idea. (And why is your personal account any shorter dated than that?)

Just don’t get greedy by buying things you do not understand: you will be ripped off. The underlying fraud level is as high as I have ever seen it.

Oh, and we are also bullish on France and Germany. Old Europe has manufacturing and production power of enormous levels. (Remember what they produced to fight wars? Their productive capacity is very high and Americans have forgotten that. They do engineering as well as anybody. And Germany no longer has a restrictive monetary policy to crush its consumer market.)

Also the French are in that lovely position of having convinced newly rich Asians that they are the arbiters of good taste. There are few higher ROE businesses. France has played Asia better than America.

We can see plenty of reasons to be bearish – but just the frauds makes our portfolio short enough. Indeed we are plenty short and likely to remain so until I can’t find frauds with ease.

Beyond that, there is a lot of pessimism around. It has got to be time to be bullish. We certainly do not desire being 125 per cent net long or hyper-aggressive like that – but we will take steps to become incrementally longer. We are if anything too short.


*Mike is not his real name.

PS. I want to stress again that my cheap mega-cap equities are relative to other things a rich guy might own – such as small cap equities, bonds, cash, commercial property or gold. There are ways cash could be a better investment – hard deflation. Long bonds are probably the best investment in that environment. I do not see that happening (though I did think it a possibility 18 months ago). Equities were generationally cheap in absolute terms March 2009. I was buying but nowhere near enough – and indeed we carried some losing shorts through the second six months of 2009.