Rational Advisor

In May I had the great opportunity in New York to meet some of the most talented investment specialists around the US. Of particular interest was David Dreman, a US Value Manager, and also Tom Marsico, a US Growth manager. For international investing we had perspectives from Daniel Geber of GLG, based in the UK.

David Dreman and Tom Marsico are some of the most famous and well respected investors in the US. David, is acknowledged as the father of contrarian investment strategy, and has written what I consider as the bible of investing - Contrarian Investment Strategies for the next generation.

Tom Marsico is the founder of Marsico Capital Management, and best known as a concentrated growth manager, who had built a great track record at the helm of the Janus Twenty Fund, before creating his own firm.

Below are key points that each manager made.

1. David Dreman and Cliff Hoover of Dreman Value Management of New Jersey.

The Dreman team had indicated that we are back to basics investing – fundamental investing, where the numbers and balance sheets mattered more that the hypes and stories. Companies with great valuations and dividends would offer better potential than those that are based on some product or future magic.

What’s interesting is that this recent crisis in financial services can be laid at the feet of one person, and one mathematical formula – those feet and formulas belong to David X Li, a Chinese citizen, who moved to Canada then the US. David had a Masters in Mathematics, an MBA, and a PhD in statistics - a very qualified propeller head. David went to work for CIBC, then Barclays and finally Goldman Sachs in the US. In 2000 he came out with a paper to quantify risks in one symbol Gamma. Prior to this the only way to measure risk was to use historical performance data. In Li’s paper he used correlation data of various defaults in credit instruments to offset risks (the rate of failure of credit), he called this result Gamma. Then, because the world wanted to boil down risk to one number (something that I disagree with) the financial system fell in love with this formula, and began to sell complex risky investments as less risky because the correlation of all of these together led to low risk. And then the proverbial waste matter hit the proverbial oscillating device. When events not factored in began to happen simultaneously, like defaults on mortgages happening at the same time. But because a lot of leverage in banks and hedge funds were based on this magic formula, we saw a massive collapse. Had the events not happened David may well have received the Nobel Prize. Where is David now, he’s working for the Chinese government doing risk management! (Here is a link to a great article from Wired magazine that goes into greater depth http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all )

Dreman believes that the term correlation does not have the same significance in risk management as it did in the past. The issue we currently is that the world is all correlated. Thanks to technology, the internet, shared resources and employment – different markets around the world go down and up at the same time.

What we have seen recently is a ten year negative number in the equity markets. These are rare events, since 1836 there have been 3 negative ten year rolling periods - and in the past every time this has happened, the forward ten years have been very positive. It did not matter significantly whether you invested one year before, or after these periods.

If we were to compare this current year to the past, we are currently closer to 1984 kind of levels and sentiments. This was a particular confusing year that arrived just after the recession of 1982. it was also the year that preceded the large recovery years of 1985 to 1987.

This recent recovery has been stoked by an unprecedented global stimulus. Dreman believes this recovery could last a year or two. However, because of this generous stimulus they do believe that inflation will be a serious force to contend with in a few years.

Much of the concerns around the leverage in the market have been removed by the recent reduction in hedge funds and leveraged accounts at brokerage firms.

Dreman’s current strategy has not changed since 1974, and it is to concentrate on dividend paying stocks, with attractive valuations, that are out of favour for short term irrational reasons, such as certain financial firms with strong management and balance sheets.

They believe that oil will return to favour, and have been adding to strong resource companies as oil prices dropped. Being contrarian does not mean blindly choosing what is out of favour, as such they believe that the auto sector will continue be in trouble for a some time, there is no easy solution to this.

A question was asked around inflation and what assets tend to do better in appreciating inflation environments. Dreman’s reply was that stocks of companies that have the ability to increase their prices during inflationary times tend to do better.

The Dreman team has an optimistic view of the markets considering the pessimism and distrust still in the markets,

2. Tom Marsico of Marsico Capital Management, Denver Colorado.

Tom finds that this maybe the most compelling opportunities he has seen since 1997, when he created his firm. Valuations are very attractive for growth managers.

As per Dreman, he believes that the Fed intervention is helping. There has been over $5 Trillion of global intervention so far. This will impact the system and provide a base of support.

Comments were made on President Obama striving to keep his word on changes. So, confidence should be had on key decisions that are being made based on the presidents acceptance speech.

You can expect, the auto sector to be much smaller in the future, and to shift its technology to more alternatives as opposed to Oil based.

Energy and Healthcare will also be changed by the Obama administration. We can expect Oil to remain within a price range because of administrations focus to foster alternatives.

One of the most attractive areas for investments, will be the financials, as Obama focuses on creating a historical win for himself as the savior of the economy. This is very akin to the FD Roosevelt era in the 1929’s when FDR’s policy led to his status as one of US’s most popular presidents.

Marsico believes that the economy has changed such that lifetime employment will be rare. Unemployment will remain high as it is a lagging indicator, and recovers after the economy has risen. New jobs will be created in areas that are not foreseeable now. An example was given of developers of application programs for the Apple iphone - these jobs were not there 3 yrs ago

Marsico believes that inflation will remain low for the next few years; it has been a primary focus of Fed Chairman Bernanke. It will not be a concern for 3 or 4 yrs. High inflation and high rates would lead to a depression, and this is something that Obama does not want that before his second term

Tom had an excited market view, if we were to return back to P/E of 16 that would mean markets would have to rise by approximately 85% to return to a new normal.

3. Daniel Geber of GLG in London, UK.

Daniels’ view is that markets have gone up to fast, and need to retrench, come back to reality, and that from this point we would appreciate at more normal rates. He however does not expect a return to recent market lows.

The main problems that caused the markets to be so volatile can’t be fixed this quick. Regulations take time to implement.

Daniel believes that recoveries will be stronger in areas like Brazil, which has a strong rising middle class, a good financial system, and a strong political base.

The main area of worries around the world belong to Russia, which has too much dependence on Oil and poor political structure. Pakistan is also a concern with its unstable political environment. Daniel believes we may see issues in Pakistan becoming headline news, as geopolitical concerns and terrorism rise up again. We are intending to avoid areas around these and surrounding countries.

Like Tom Marsico, Daniel believes that inflation will remain lower for a few years then rise up, and that this may be positive for equities.

Because of demand and supply considerations, Oil is to remain close to current levels, we are at the right price.

The international scene for autos is a lot more encouraging than in the US, GLG likes them, especially smaller European and emerging market companies and suppliers. The US may move to alternatives, but the higher prices for these vehicles means they will be avoided in emerging markets. They will still buy old fashioned oil burning cars

Daniel remains cautious in the short term, but optimistic in the long term for international equities. There are still causes for concern, but not causes for panic. We may still see periods where the equity markets pull back, some retrenchment, but it’s unlikely that there would be wholesale selling or capitulation as we saw in the latter part of 2008.

In Summary

The overall consensus was that we may well be beyond the worst parts in the markets. Valuations are exceptionally attractive, and careful selection is critical. Remember that investing is a probability game. The key to successful investing is to carefully select investments, which given their probabilities and characteristics, are the closest match for your investment objective, time horizon and risk tolerance. Then sit back and be patient.

Investing is still a smart long term idea.