Wednesday, March 07, 2012

Fortunes Are Made in Recessions

"The list of famous companies founded during economic downturns is long and varied. It includes General Motors, AT&T, Disney and MTV, all founded during recessions. A 2009 study found that over half of Fortune 500 companies got their start during a downturn or a bear market." - The Economist

I made the same argument to investors in 2008 and 2009.

It's the same argument I'll make to you now.

Yes. The market is risky. And yes. It could fall further.

But that doesn't mean you shouldn't take a punt.

It's important you look past the bad news and use part of your portfolio to invest in speculative assets... particularly small-cap stocks. I'll explain which small-cap stocks shortly. But first...

Why is it a recession results in the creation of so many companies and ideas? The Economist newspaper offers a couple of ideas...

It suggests, "clever entrepreneurs may see an opportunity to set up businesses that give them what they want more cheaply or efficiently."

Another suggestion is, "many who might otherwise have sought a stable salary will reinvent themselves as entrepreneurs."

We're sure there's something to both arguments. I'd say it's down to another reason it mentions: "Credit is scarce."

When the market falls, it's harder to find investors. Because people are more careful with their money. That means they'll pay less for shares (that's why share prices fall), and lenders will demand a higher interest rate to take into account the higher risk.

So when you see share prices fall, it's a signal investors are being careful with their money. This is exactly what has happened over the past 10 months. But investors won't stay cautious forever. A time will come when they'll see value in stocks.

And at the moment, I see value in many small-cap stocks.

The thing is, if this is supposed to be a downturn, how come there's billions of dollars going into huge infrastructure projects here and overseas?

Let me explain...
 


Multi-Billion-Dollar Infrastructure Spree

Bloomberg News reported recently:

"Australia is set for a $112 billion infrastructure boom as the nation adds ports and railways to feed China and India's appetite for coal and iron ore...

"Leighton Holdings, Australia's biggest builder, Bechtel Group and train maker General Electric are among companies winning deals as Australia adds transport links to support $232 billion of mineral and energy projects."


Another report from Bloomberg revealed:

"Thirty-four years after Black Monday, the day Youngstown Sheet & Tube announced shutdowns marking the end of the Ohio city's steel era, a $650 million mill is coming to life thanks to the natural-gas drilling boom.

"The factory for Vallourec SA's V&M Star will have 350 workers and produce seamless pipes used in hydraulic fracturing, also known as fracking. It's part of a development that an oil and gas industry study calculates will mean more than 200,000 jobs and $22 billion in economic output in Ohio by 2015 - and which has neighbouring states looking to get in on the action."


And The Age said:

"Japan's Inpex Corp said it has made a final investment decision on the Ichthys liquefied natural gas export project, paving the way for Australia to surpass Qatar as the world's top exporter of the fuel by 2017.

"The 8.4 million tonne per annum (mtpa) project near Darwin will cost about $32 billion, some 70 per cent more than Inpex's $20 billion."


That's a lot of cash.

It's also important to remember that infrastructure projects are long-term investments. They don't happen overnight. Many of these have been on the drawing board for years, when the global economy was booming.

Only now are they seeing the light of day.

Of course, there's no guarantee all the proposed projects will go ahead. There's a chance some investors will lose their nerve and decide against funding them. That will be bad news for the companies directly involved in those projects.

It may not be so bad for all stocks. I believe stock prices have already priced in a lot of the downside. Why do I say that?

Well, a good indicator of market sentiment is the U.S. listed Market Vectors Oil Services ETF [NYSE: OIH]. It tracks the performance of oil services companies. It includes big companies such as Halliburton Co, Schlumberger Ltd and Baker Hughes Inc.

The reason this ETF is a good indicator is that it tends to outperform during a bull market and underperform during a bear market. As the following chart shows (OIH - blue line; S&P 500 - red line):


chart of OIH and S&P 500
Click here to enlarge

Source: Google Finance

What you can't clearly see on the chart is that over the past six months, the ETF has fallen more than 20% while the S&P 500 is roughly where it was six months ago. 

Now, that's not to say OIH won't fall further, because that's possible. All I'm saying is investors have already priced in a negative outlook for the resources sector. And to me, that's exactly when I want to buy... when others are less keen.

That's part of the reason why I believe the energy sector is good value. Another reason is this...



Biofuels Out, Fossil Fuels In

One of the most eye-opening stories I came across was in the Financial Times. It was titled, "Biofuels expansion stalls on output drop".

The article explains...

"The growth of the biofuel industry has come to an abrupt halt with annual output last year falling for the first time in a decade owing to poor margins in Brazil and the US, the world's biggest suppliers.

"Global biofuel production dropped to 1.819m barrels a day, from 1.822m b/d in 2010... The rapid expansion of the biofuel industry over the past 10 years has been controversial because it transforms food crops such as corn, sugar, palm oil and wheat into fuels."


This is good news for oil and natural gas. Why? As Amrita Sen, oil analyst at Barclays Capital says, "The less biofuel you have the more gasoline you need."

I'm not against biofuels. But at the moment I believe the better value and outlook is in fossil fuels: oil and gas.

Alternative energy stocks - including biofuel stocks - have one major disadvantage at the moment: they are at the mercy of government subsidies. But because governments take so long to decide which alternative energy sources to back, it's hard for investors to know which stocks to back. 

Should you invest in biofuels, solar, wind, wave or fuel cells? Until governments decide which energy source they'll back with subsidies, fossil fuels will keep their advantage.

The other disadvantage for biofuels is the dual nature of the source. Because it relies on edible foods, producers of corn and sugar have a choice of where they sell their crops. If food producers pay more for crops than biofuel producers, then they'll sell to food producers. 

So, in order to secure the supply, biofuel producers would have to pay a higher price and that could put pressure on profit margins... and threaten the viability of the industry.

As the FT article explains, without tax subsidies the biofuel industry is a marginal business at best...

"The impact on US companies would be exacerbated by the end of a tax credit on ethanol of 45 cents a gallon and a tariff of 54 cents a gallon that protected them against cheaper Brazilian ethanol."

Bottom line: while you can still expect to see a lot of volatility in the market - including the energy sector - I believe the three reasons I've given show that it's a good time to punt on energy stocks now.

Cheers,
Kris.

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