2 Gurus Have Contrasting Views on the Economy and Market
When two highly regarded gurus paint contrasting pictures about the future of the global economy and stock market performance, investors often find it difficult to select the best course of action. The stance on hoarding cash by Ray Dalio (Trades, Portfolio) and Warren Buffett (Trades, Portfolio) during the early days of this year is a classic example of such a situation. As the U.S. economy attempts to recover from the painful lows seen during the first half of the year, two legendary investors, David Einhorn (Trades, Portfolio) and Seth Klarman (Trades, Portfolio), have decided to follow two different approaches in the hopes of beating the market. This analysis will summarize the differing viewpoints of the two gurus and recommend a strategy that could help generate attractive returns in the long run.
GDX 30-Year Financial Data
The intrinsic value of GDX
Peter Lynch Chart of GDX
Einhorn bets on a strong recovery
In a letter to Greenlight Capital investors, Einhorn elaborated on the analysis behind the largest positions in the fund's portfolio. From this explanation, it's easy to conclude he is expecting a robust recovery of the American economy in the next couple of quarters and has rebalanced the portfolio to include companies and exchange-traded funds that would perform well during an inflationary macroeconomic environment. He wrote:
"We ended our last quarterly letter with a promise to discuss how we have been positioning the portfolio in anticipation of rising inflation. An inflation bias was already embedded within the portfolio. We have owned gold for a long time in our macro book. During the quarter, we adjusted our position by reducing our direct exposure and adding the VanEck Vectors Gold Miners ETF (GDX) and a small position in a speculative gold miner. A number of our existing long equities have exposure to rising prices, including Green Brick Partners (NASDAQ:GRBK) for house prices, Brighthouse Financial (NASDAQ:BHF) for equity markets and eventual higher long-term interest rates, CNX Resources (NYSE:CNX) for natural gas prices, The Chemours Company (NYSE:CC) for titanium dioxide prices, and Buzzi Unicem (MIL:BZU) for cement prices. We added a new medium-sized long in Teck Resources (NYSE:TECK), which should benefit from base metal price increases."
In addition to these investments, Greenlight has entered into inflation rate swap agreements, which is a clear indication that the guru is expecting a notable uptick in economic activities over the next few months. A letter dated Aug. 4 suggests that these financial instruments could net his fund double-digit returns in the base-case scenario.
"Inflation swaps are a highly liquid derivative of Treasury Inflation-Protected Securities (TIPS), the value of which are based on the official CPI at a future date. In May, we observed that the 2-, 5- and 10-year inflation swaps implied future annual inflation of approximately 0.1%, 0.8%, and 1.3%, respectively. As annual inflation has averaged 1.7% over the last 10 years, we recognized that we could make a substantial return if actual inflation merely reaches the long-term average. If inflation turns out to be even higher, so much the better. Accordingly, we created a new, large macro position in 2-, 5- and 10-year inflation swaps. At quarter-end, inflation expectations had already begun to rebound to 1.3%, 1.4%, and 1.6%, respectively."
The guru's view on the economy is consistent with that of the International Monetary Fund and the World Bank as these institutions project the global economy to brush off the challenges and stage a massive recovery in 2021.
Klarman is not convinced about the imminent recovery
It's no secret that the Federal Reserve has been a driving force of markets since late March. From cutting interest rates to near-zero levels to purchasing corporate bonds, the policymaker has deployed an array of stimulus tools to revive the economic growth of the U.S. Even though many investors would not complain about the historic bull run in the second quarter, billionaire hedge fund manager Seth Klarman (Trades, Portfolio) believes the market is substantially detached from the fundamentals and he claims the Fed has played a major role in pushing markets into overvalued territory. In a letter sent to shareholders of Baupost Group on July 20, Klarman wrote:
"Surreal doesn't even begin to describe this moment. Investor psychology is surprisingly ebullient even though business fundamentals are often dreadful. Investors are being infantilized by the relentless Federal Reserve activity. It's as if the Fed considers them foolish children, unable to rationally set the prices of securities so it must intervene. When the market has a tantrum, the benevolent Fed has a soothing yet enabling response."
He continued to confirm that his hedge fund had been a net seller of the market during the three months ended June 30, which came as a surprise to many investors who are betting on risky assets in the hope of stellar global economic growth in 2021 and beyond. The primary concern cited by the guru is the absurd valuation multiples at which many profitable companies are trading. The Shiller price-earnings ratio confirms this overvaluation as the current reading is 87% higher than the average multiple of 17.1.
Source: GuruFocus
Even though average multiples have drawbacks, such as placing a higher weight on historic performance instead of expected growth in earnings, a significant detachment from the mean should be considered a warning sign.
This is how to strike a balance
The two contrasting opinions of Klarman and Einhorn might cloud the judgment of an investor. A good starting point to evaluate the two approaches to the market is to understand the principles followed by each one of them. According to documents filed with the Securities and Exchange Commission, Klarman's Baupost follows value investing techniques, which is made clear in this excerpt from its prospectus.
"The Fund pursues its investment objectives primarily through direct investments in common stocks, preferred stocks, debt securities, and other securities. These securities are analyzed and researched by The Baupost Group, taking into account, among other factors, the relationship of the market value of the securities to book value, cash flow, and earnings to determine if they are available at prices less than their intrinsic value."
Einhorn's Greenlight Capital, on the other hand, is designed to be more active in the market. As a result, the guru will exploit opportunities that might be considered too risky by a value investor. The below is an abstract of the investment strategy statement filed with the SEC as part of Greenlight's prospectus.
"Our investment strategy is designed to maximize returns over the long term while minimizing the risk of capital loss. Our strategy is to invest in long and short positions primarily in publicly-traded equity and corporate debt securities."
Investors should carefully evaluate their investment preferences, objectives and risk tolerance to determine which guru's advice and actions need to be followed to generate the desired returns from stock market investments. Blindly following a very successful investor and his moves might lead to disappointing returns if the characteristics of such an investor do not tally with that of the retail investor.
Analyzing the sector weighting of each guru could help determine the best course of action as well. Using the dedicated page for this section on GuruFocus is one of the easiest ways to evaluate whether a highly regarded investor is betting on the same industries and business sectors as a retail investor, which could then be used as a screening tool to filter for gurus whose strategies resemble with that of an individual.
Takeaway
When gurus cause confusion among investors regarding the expected performance of equity markets, it's best to take a step back and dig deep into the investing styles of all the gurus involved. This exercise often helps identify the reasons for inconsistencies among well-known investors. Going a step further, one could always evaluate macroeconomic indicators independently to determine whether the results would be similar to conclusions drawn by gurus.
The global economy has hardly gone through an uncertain period of this magnitude as the recovery of the economy could begin as soon as the next quarter or, in the worst-case scenario, mid-2021. The best way to play this significant uncertainty is to remain invested in free cash flow-positive companies with strong balance sheets.
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
Skyworks Solutions Has More Gains Ahead
The Right Way to Be Greedy When Others Are Fearful
The Market Could Head Higher Despite the Contraction in GDP
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.
