Monday, November 17, 2008 0 comments

Deflation a dagger to the heart of value investing?

I'm not in the deflationary camp--used to be but am neutral right now--but what if we face a deflationary bust? How would various investment styles work if we actually enter a deflationary period? It's not good to hear this but Seth Klarman supposedly thinks that deflation is a dagger to the heart of value investing. Let me quote a summary of Seth Klarman's book, Margin of Safety, by Ronald R. Redfield:

Sure enough he discusses deflationary environments. He [Seth Klarman] explains how deflation is "a dagger to the heart of value investing." He explains that it is hardly fun for any type of investor. He explains that value investors should worry about declining business values.

I don't consider myself a pure value investor but those that are, should pay attention to what he says. Klarman suggests the following items to keep in mind in a deflationary scenario:

Yet, here is what he [Seth Klarman] said value investors should do in this environment.

a. "Investors can not predict when business values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value and other methods."

b. Investors fearing deflation could demand a greater discount than usual. "Probably let more pitches go by."

c. Deflation should give greater importance to the investment time frame.

The key risk is that asset values will be marked down. Not just once or twice, but continuously.

I wonder if this means that growth stocks will be easier to deal with. High quality debt is what typically does well in deflation. For example, Japanese investors who bought a 10 year bond in 1990 made a killing while stocks, real estate, commodities, and currency slid (I think the currency would have appreciated if the government didn't try to keep it down.)

Before someone gets the wrong impression, I am not in the deflation camp. However, the market is assuming we will face a deflationary bust. That's why 3 month T-bills are yielding 0.12%, 1 year T-bills yield 1.08%, 2 year Treasury yields 1.23%, and the 5 year Treasury is yielding 2.33%. Think about what the market consensus right now is. People are willing to invest for 2 years at 1.23%! If you want a real return of, say, 3%, then you are really expecting an inflation of -2.8% for the next 2 years.

The ultimate contrarian bet here is to go against the market and assume an inflationary scenario. But this is very dangerous because even if you ignore the deflationary scene in USA (and developed countries in general,) China may face a big deflationary bust regardless. So the simplest position for those macro-oriented is to stay neutral. Inflationary outlook is very risky as mentioned, but a deflationary scenario means you are paying a high price for comfort. A deflationary bet of buying US Treasuries may be the greatest investment for the next 10 years (as was the case in Japan--although rates were slightly higher in Japan at that time) but it could also turn into a disaster of epic proportions (especially if the US$ also declines.)


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