Where to Find Today’s Values

The last few months have taught the benefits of diversification, balance, and a margin of safety.

One of our investment themes of the last few years is that U.S. stocks and bonds are in a declining phase of the valuation cycle. It will be a while before investors are willing to take great risks and pay high prices for U.S. stocks the way they did in the late 1990s. Instead, the indexes will be flat over the long term, with a series of rolling bull and bear markets within the longer-term cycle. As you probably know, there has not been a net gain in any of the stock indexes between 1998 or 1999 and now.

Bonds also are highly valued and not likely to bring high returns in the near term.

Despite the long-term outlook, there will be pockets of opportunity in U.S. stocks in those rolling bull and bear markets. In addition, there will be opportunities in other markets around the world.

Investors who stick to index investing in the U.S. stock and bond markets have been disappointed the last few years and likely will be disappointed over the next few years. Investors who consider a range of assets and purchase those with margins of safety and the potential for growth will be rewarded.

We’ve seen the benefits of that approach. The big winners for investors lately have been energy, other commodities, real estate, Latin America, and small international stocks. We have not had all of these in our Sector and Balanced Managed Portfolios, but we have had enough of them to keep our portfolios moving forward.

Sector and Balance Managed Portfolios

The big winner in these portfolios recently is PIMCO Commodity Real Return. While commodities had a temporary surge in late August and early September because of a panic after Hurricane Katrina, that portion of the gains quickly was reversed. But the case for long-term gains in commodities remains.

Economies worldwide continue to grow, increasing demand for many commodities, not just the energy complex. It will be a while before new investments in commodity infrastructures can increase supply enough to more than satisfy demand. Until then, there should be an upward trend in commodities. There will be volatility in the sector. But don’t be scared out of the investment by short-term news. Without a sharp slowdown in worldwide economic growth, the investment should remain profitable.

I like the PIMCO fund because the index it tracks is well-diversified among different types of commodities. Other commodity funds generally track an index that is heavily weighted toward the energy sector.

International stocks, especially smaller ones, also are doing well. Tocqueville International Value and Third Avenue International Value soared the last few months. TIVFX returned over 10%, while TAVIX returned 7%. The Tocqueville fund is the more volatile. Smaller international companies remain one of the best values in the world’s markets. These two funds allow us to benefit from this sector while maintaining a margin of safety.

In the U.S. markets, larger companies are the better value. Small company stocks have been on a strong run since 2000. Usually smaller company stocks have lower valuations than larger company stocks, to compensate investors for the higher risk of smaller companies. Recently, the gap has narrowed. That has made larger company stocks a better value. We own both growth and value positions through Chase Growth and Oakmark funds.

While larger U.S. companies are a better value than smaller companies, they are not a true value on their own. That is why we own only funds that invest with a margin of safety.

Chase Growth invests in growth stocks but is more conservative than other growth stock funds. It has shown its mettle by preserving more of its capital in the bear market than most other growth stock funds. The fund uses a combination of fundamental and technical factors to decide which stocks to own and, importantly, when to sell.

Oakmark, like Chase, owns a small number of stocks that the managers like. Oakmark searches for deep values more than Chase does. Oakmark also looks only at fundamental factors. It does not consider technical trends when deciding which stocks to buy and sell.

A portion of these portfolios remains in money market funds. That reflects the paucity of good values in the markets. We’ll invest this money when opportunities with a margin of safety are identified.

Income and Income Growth Portfolios

Volatility and uncertainty dominated the income markets. Yet, most income investments are at roughly the same values now as they were a month or two ago.

Longer-term rates surged over the summer. Some analysts believe that was due to fears of a surging economy that would bring higher inflation. Others believe it was due to a manipulation or unusual trading in the bond futures market. Whatever the cause, rates fell quickly when Hurricane Katrina spurred fears of a rapid decline in economic growth.

We have been conservative with income investments for the last year. While long-term interest rates have not rise as we expected, the risks of higher rates were too high to venture out of short-term bonds. That did not look like a good move at times, because longer-term bonds had months of strong returns. But those returns were not sustained. Over the last year, Vanguard Short-Term Investment Grade, in which we were invested much of the last year, has had about the same total return as PIMCO Total Return and other longer-term bond funds.

Last month we moved the Managed Portfolios primarily into money market funds. These now have yields comparable to those of other bonds, and yields on the money market funds will rise without a risk to principal. As the Fed continues to increase short-term rates and the economy grows, there still is a strong potential for longer-term rates to rise. With money market rates now close to the yields on many bonds, you receive little compensation for taking the risk of higher rates. We’ll stick with the money market funds for now and wait for the markets to create an opportunity.