Significant Index Decline Equals Significant Buying Opportunity for Active Managers.

For many investors, the first month of 2016 has started off on a down-beat note. A total and utter collapse in oil prices based upon oversupply, as was predicted in an earlier post, has come to fruition. Those that were long energy investments, those that owned companies supplying goods and services to that sector of the market or those who financed the homes and consumer purchases of energy workers, have been savaged.

The CEO of Kansas City Southern Railroad characterizes the US economy as being in an energy sector depression, an industrial & manufacturing sector recession with a consumer spending expansion. An overall economy with such a divergent composition, quite obviously, punishes those investors overexposed to the former industries.

The “sad-sack” composition and appallingly poor business performance of an inordinate number of stocks within the Dow Jones Industrial Average greatly exacerbates matters. When a full 17% of the index names are either troubled businesses or pure commodity producers/suppliers, the index is more representative of the name “Dow Jones Industrial BELOW average“.

Few investors would feel comfortable having their personal portfolio with a 17% weighting in cyclicals and cigar-butts. Companies such as American Express and IBM have been struggling, from a business perspective, for multiple years; I question why ANYONE would want to own either of those stocks on their individual merits. Caterpillar, Chevron and Exxon are clearly hurt by low oil and commodity prices worldwide. Base material prices have fallen off a cliff, precious metals have no lustre and foodstuffs such as wheat are selling for five year lows. Companies that produce these products and businesses that supply machinery and equipment to such industries have had their legs sawn out from underneath them.

It would be refreshing indeed to find a broadly based large cap index comprised of the BEST that the equity world has to offer. Given the wretched composition of most of the widely quoted industrial indexes there is little doubt why investor sentiment is so dour.

For those portfolios that have been savaged in the oil rout; in truth, it is difficult to be sympathetic to their travails. In China, for more than one year, Xi Jinping has telegraphed, quite clearly and succinctly, that the era of rampant infrastructure spending and plant-building to increase industrial capacity and fuel GDP growth is over. The emphasis for the Chinese economy, it was stated, was to increase the demand for services and consumer goods and to shift away from pure basic manufacturing, commodity processing and raw materials production. At face value, one would readily and quickly determine that such a change in Chinese industrial policy would result in diminished rates of consumption growth in energy. It certainly took no special skill or clairvoyance to review the abundance of hard data, across a variety of platforms, to determine that global oil supply growth outpaced global demand growth in 2015. Once again, only those that were talking up their own book would fail to conclude that such oversupply would result in negative price adjustments. And it was not particularly prescient to determine that a slowing demand for energy by China, coupled with a dramatic oversupply of oil on the production front could result in a brutal reckoning for any whose investment portfolio or livelihood was heavily exposed to energy. Yet, as always, the investment community appears temporarily flummoxed by the resulting losses. Once again, the loudest and most strident voices have determined that bad news for one sector spells the end-times for entire equity markets on a global basis. I disagree.

The developed world economy is, for the sake of simplicity, roughly divided up into two camps. There are countries that are not energy independent (importers) such as the United States and most of Europe. For these nations, low energy prices are a benefit. Then, there are those countries that are energy independent exporters, such as Russia, Norway and Canada. Their fortunes are so heavily tied to the price of oil that they may as well be considered petro-economies with petro-currencies. Such nations live off of export rents. Absent other industries capable of picking up the slack, those economies are sunk and may be sunk for a very, very long time.

Those that are presently long energy remain so either (involuntarily) due to the inclusion of energy investments within their index holdings, or, alternatively and perhaps naively, they purposefully continue to hold under an assumption that oil will recover sharply in price, as it has in the past and that all will be well. In the latter camp, oil bulls consider the current oil price destruction to be a buying opportunity. Perhaps this is the case. In order for them to be right, China will need to revert back to an industrial policy based upon heavy manufacturing. Is that likely? Without a doubt, there are also many that have fallen into the “deal with God” bargaining camp. These speculators promise to never, never, never own any oil investments, ever again, so long as God raises the price of oil enough that they can get out at a break-even or maybe even a small profit to account for their stress.

The Sunni-Shia schism of Saudi Arabia and Iran is an important issue that should not be overlooked. Both nations, in my view, hope to beggar the other into discontinuing the current proxy wars in Yemen and Syria. While Saudi Arabia is a lower cost producer, Iran’s fiscal coffers will soon be replenished from capital formerly tied up in sanctions. Iran has lived through tough economic times before and has demonstrated an ability to withstand continued economic pain; just how much economic pain, if any, Saudi Arabia is prepared to endure is another matter entirely.

Finally, in order for oil to return back to old levels, the global rise in the use of wind and solar power, as well as notable improvements in conservation of energy and more efficient appliances, more efficient power generators and more efficient automobiles, will need to cease. While I am not a fan of subsidized wind and solar output, increased generating capacity by those sources does chip away a little, at the margins, for oil demand. When one produces a commodity whereby even one barrel of overproduction results in a price decrease, substitution demand destruction can be hurtful. For more than a year now, global economic growth has outpaced demand for fossil fuels. Instead of “peak-oil”, could it be that we have seen “peak-demand”?

Should the global economy be experiencing the point of oil “peak demand”, then much more pain lies ahead for the producing nations. If this is not purely a cyclical price crash, economic rents will dry up and budgetary shortfalls will need to be addressed through tax increases. In some nations, the shortfalls could be such that national policy changes could become confiscatory. Markets are aware of this; many will choose to avoid capital investments in such locales. For the producers of oil, for the employees of those companies, for the bankers to those companies and for the homebuilders for those regions, the pain may have just started. The financial leverage in most of those industries is alarmingly high and was only considered feasible at prices well above current forecasts.

While there are some lingering fears of profit declines in companies or sectors with indirect exposure to the energy price crash, those who are not heavily directly or indirectly exposed to the energy markets shouldn’t be overly concerned by the current gyrations in global markets. Risk-off selling hits all rather indiscriminately during period of panic; such is the nature of linked markets.

Some noted value investors espouse the picking up of “cigar-butts”. I am not a value investor and don’t cotton to such thinking. In particular, the Chinese reorientation, away from heavy industrial output, in favor of consumer goods and services, doesn’t stop at oil; it impacts all commodities in varying degrees. EBITDA margins in many industries, especially those where many cigar-butts are found, will fall. There are probably more value traps in low margin industries, and in certain widely quoted equity indexes, than there are true values. Likewise, companies that are not self-financing won’t get into my investment universe for coverage or ownership.

That said, the recent pull-back of high quality investments with strong secular drivers deserves to be noted. World class global firms have fallen as sharply as the trash in the current risk-off phase. Some of these world class growth stories should be accumulated, provided that their investment case remains strong.

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