Thursday, April 22, 2010 4 comments

One year industry performance from a potential multi-decade bottom

Sorry about the lack of investment-specific posts. I find the market unattractive and haven't really run into anything worth contemplating. Most of my time has been spent thinking about a bearish outcome in China and investigating Mega Brands (TSX: MB.) One of the biggest dangers I see is that many appear over-confident due to strong gains in the last year. Given the big rally in almost everything (except US Treasuries), it's hard to tell if someone was lucky or knew what they were doing.

In any case, as I have done regularly in the past, I thought I would try to gauge where contrarian opportunities may lie. Since a multi-decade bottom may have occurred almost exactly an year ago, I thought it was good time to see the performance of various industries. I should warn people that the industry performance results depend on the industry definition used. Dow Jones' definition can be misleading and the numbers may also be wrong at times (sometimes the case with OTC stocks in these indexes.)



One Year Return

The following table from WSJ Market Data Center shows the top performing industries (according to Dow Jones classification) over the last year:



It shouldn't come as a surprise to long-time market watchers that the top performing industries are almost all cyclical. Some of you may recall that a key contrarian strategy is to buy cyclicals when they are depressed (usually during recessions.) This ranges from the forestry & paper, to automobiles to travel & tourism. The best return was posted by forestry and paper, with a 1 year return of 246.75%.

Long time readers may recall how I was following the forestry sector for a long time and felt it was a worthwhile industry. I was too scared to invest but it just goes to show how quickly they can turn around. I recently saw Benj Gallandar of Contra the Heard remark on BNN that forestry stocks are worth considering (as a contrarian.) However, it's still not clear to me that the industry is out of the woods ;) The Contra the Heard managers lost their shirt investing in AbitibiBowater and so did other successful investors like Fairfax (my guess is Fairfax took a loss in excess of 80%—I believe they bought bonds too so it depends on how you count their position.) It's still not clear to me that the forestry and paper industries have restructured sufficiently.

The forestry industry is an example of how 'getting in too early' can turn into a disaster. One really had to buy them late last year or else they would have suffered catastrophic losses—same thing with autos and auto parts.

Given the increase in risk appetite, it shouldn't be surprising to see "safe*" and low-volatile industries such as water, electricity, and telecom posting the worst returns over the last year. The worst return of 0.28% was posted by the mortgage finance industry. This industry contains mortgage lenders as well as mortgage insurers (for what it's worth, mortgage insurers such as Radian, MGIC, PMI, and Triad Guaranty have posted returns over 75% in the last year but the mortgage lenders haven't rallied much.)

Five Year Return

Five year industry returns, as of April 22, 2010, are shown in the table below:



Most of the top performing industries are commodity industries. This is similar to how the situation stood back in June of 2009. In contrast, the bottom performers have shifted around a bit. Full line insurance held the worst spot when I looked at it last year and it is still the 2nd wost performer with a 5 year return of -90.94%. The worst performance spot has been taken up by the mortgage finance industry, whose 5 year return of -94.77% would make even a billionaire investor cry ;)

The interesting thing is that some of the worst performers as of last year, such as forestry & paper, automobiles, and airlines are not in the bottom 10. The rally from the bottom was so strong that they recouped some of their losses. These industries are in an interesting spot right now. On the one hand, they are not the worst industries and hence may not show up on contrarian screens; at the same time, they are not exactly surrounded by hype and making the front page news. If you think some of these industries are on the way to recovery, it may be worth investigating. For instance, I am neutral on it and wouldn't go near it, but if you were bullish on autos, a company like Ford (F) is a quasi-contrarian pick right now.

One surprise to me on the worst performer list is the mobile telecommunications industry. I never would have thought it would post such terrible numbers, let alone something worse than banks, aluminum, and publishing. Looking at the components of the industry (click on the industry link on the WSJ screen,) it seems that the components posting the big losses are mostly emerging market mobile telecoms. I'm bearish on most emerging markets (EM) but if I weren't, I would start looking at those EM mobile telecoms.

Summary

To sum up, the best medim-term performers continue to be commodity businesses or those that depend on a commodity bull market (such as railroads.) After the monster rallies in some industries, the list of the worst ones has changed. I hate to end up with this conclusion but I don't see any contrarian industries that stand out. Alluding to the amount of wealth creation in banks, they are still not the worst performing industry in the last 5 years. That is, even after the collapse, bank investors, at least going by the Dow Jones definition here,  have lost less money** than the hapless investors in aluminum companies, home construction, or mobile telecommunications.



Footnotes:
* Of course, "safe" has nothing to do with industry—as Jim Grant would say, at a sufficiently low price, almost anything is safe; at a high price, almost nothing is safe—but I'm going with the general consensus view of utilities/telecom/etc as being safe investments.

** Do note that even though banks have posted a smaller percentage loss, more wealth, in dollar terms, was likely lost by bank investors. This is because the market cap of banks are larger than some of these industries with worser performance. Also, there are different industries within the banking complex and this Dow Jones sub-index is only referring to a narrow portion of it.

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4 Response to One year industry performance from a potential multi-decade bottom

Parker Bohn
April 23, 2010 at 12:45 AM

Those 5 year numbers are interesting.
Basically, the data show  that no one had any clue 5 years ago how to pirce these industries.
By extension, I'm assuming that no one has any clue today how to price these industries.

Unfortunatley, I also don't think I have any skill at industry picking, so as an individual investor I just try to avoid having too many correlated investments.

One benefit of small-cap value investing is that these investments are often largely uncorrelated with each other, which helps to control risk.

Sivaram Velauthapillai
April 23, 2010 at 1:38 PM

Couple of quick thoughts on your comments...


Parker Bohn: " Basically, the data show  that no one had any clue 5 years ago how to pirce these industries. By extension, I'm assuming that no one has any clue today how to price these industries."


I like to think of the price changes as capturing the structural changes in the economy. Over the long run, some industries are rising while others are falling. Although a purchase would look like an incorrect price in hindsight, it's hard to tell at the time.

For instance, commodity stocks appear frothy to me but the pricing is simply reflecting the bull market in commodities. The structure of the economy has changed over the last decade, with commodity producers earning a big chunk of the profits compared to, say, manufacturing or other value-added process industries (at least from an American point of view.)




Parker Bohn: "One benefit of small-cap value investing is that these investments are often largely uncorrelated with each other, which helps to control risk."


I don't generally invest in small-caps becaues I'm trying to be a Buffett-type investor (small caps generally have no moat and are vulnerable to being dislodged, not to mention questionable corporate governance.) However, even though I don't generally target them, I do think I do agree with you that they are uncorrelated with each other (small caps are likely to be mispriced more as well.) But...

In my view, what matters is whether the asset is uncorrelated with the economy... and not whether it is uncorrelated with each other. Having uncorrelated assets (with each other) simply reduces volatility but so what? There is some benefit for passive investors who re-balance their portfolio regularly but I don't see the benefit for active investors.

I don't think holding lowly correlated assets reduce risk at all. Some of the biggest losses during the crash was from endowments who had very low historical volatility in their portfolio.

MrParkerBohn
April 24, 2010 at 3:40 AM

Sivaram "I like to think of the price changes as capturing the structural changes in the economy."

I agree, price changes should (and do) reflect macro changes.  In theory, however, prices today should already reflect future structural changes.

The point is, the prices 5 years ago obviously did not anticipate structural or macro changes very well at all, or there would not have been such a huge dispersion between the returns of different industry groups.

I could be wrong, but I'd wager that if we could see 5 years ahead, the results would also be surprising (ie not already priced into current asset values).

Sivaram
April 24, 2010 at 2:45 PM

MrParkerBohn: "I could be wrong, but I'd wager that if we could see 5 years ahead, the results would also be surprising (ie not already priced into current asset values)."



Yep... not only that... you and I wouldn't have any chance of making money (or at least excess returns)... the day will come when blogs like this and readers such as yourself wouldn't be in business ;)

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