Sunday, February 17

Week 85 - 15 Low-risk Food-related Stocks vs. Gold

Situation: Food-related companies have been outperforming every other category of stocks (aside from gold bullion ETFs and pipeline companies) for the past 10 yrs. For most food-related companies, that performance comes with relatively little risk using 3 measures that characterize a group of above-average performing hedge funds (see Week 46):
   a) Losses during the Lehman Panic less than 65% as great as losses for the S&P 500 Index;
   b) 5-yr Beta less than 0.65;
   c) returns that beat the S&P 500 Index over extended periods. 

Unfortunately, the fees levied by most hedge funds (e.g. 20% of any outperformance vs. the S&P 500 Index) will absorb a large share of your earnings, so you might as well have invested in the lowest-cost S&P 500 Index Fund with the longest history (VFINX). There are less costly substitutes for hedge funds that offer the 3 hedge fund characteristics mentioned above and they are: Warren Buffett's Berkshire Hathaway (BRK-B) which is a hedge fund disguised as an insurance company, Vanguard Wellesley Income Fund (VWINX) which is a bond-heavy balanced fund that behaves like a hedge fund, USAA Precious Metals and Minerals Fund (USAGX), and Royal Gold (RGLD) which is a US company and Dividend Achiever that invests in royalties from precious metals and minerals mining operations worldwide.

Surprisingly, there are a number of food-related companies that have better prospects going forward than either bonds or gold. We have identified 15 of these companies (Table) that have delivered strong returns over the past 20 yrs and satisfy the above 3 requirements for a hedge fund. To date, bonds and gold have been the main hedges that back the risky bets favored by managers of hedge funds (e.g. emerging market stocks). The shifting prospects of regional and global food demand relative to weather-induced shortages give pricing power to food-related companies--just as the coming wave of retiring baby boomers gives pricing power to gold. [This is because the government has not yet come up with a way to keep its current pension and health care programs solvent.] 

Many investors have shied away from stocks and moved into bonds. This has been at least partially due to the Recession (circa 2000) being followed closely by the even worse Lehman Panic (2008). I can’t blame them, given that the annualized total return on Vanguard’s S&P 500 Index Fund (VFINX) over the past 15 yrs is 4.5% vs. a 7.6% return for 20-yr US Treasury Bonds held in an exchange-traded fund (TLT). But don’t start transferring your funds just yet because bonds aren’t looking so good now. Interest rates are low because all bonds are linked to US Treasuries and the Federal Reserve has been on an unprecedented bond-buying binge since 2009. The US Government had a crummy balance sheet before the Lehman Panic, and now its debt is more than 4 times its annual income from taxes. And it continues to use borrowed money to pay over 20% of its bills.

Investors are shell-shocked from what happened to their stocks during the the recent recessions, and now they’re becoming frightened by the prospect of hyperinflation that will wipe out their bonds. So where do they invest their shrunken wealth? They put it into gold, which has worked well, at least so far. But gold is costly to buy, has to be insured, and produces no income. Those costs are reasonable during low inflation but will bite during high inflation.

We’ve explained why gold is a reasonable asset to own during a Financial Repression (when large-scale bond purchases are made by a central bank to restart economic growth). But we also noted in those blogs (see Week 79) that it would be unreasonable to continue owning gold after Financial Repression ends. Exactly when will that be? On February 5, 2013, the Congressional Budget Office (CBO) released a report explaining that tax revenues are now increasing due to an improving economy, and increased tax rates on high income households. In the meantime, the deficit is shrinking because spending on unemployment insurance and other “safety net” programs is decreasing and troops are returning home. But the CBO spokesperson, Douglas Elmendorf, said the budget gap would begin to worsen later this decade: “The number of people eligible for Social Security retirement benefits will be 40% higher in 10 years than in 2012.” 

How should investors prepare for that? One way would be to diversify your investments and hedge against the possibility that Congress will act to restore the government’s balance sheet to health, as occurred during the Clinton administration. An investor can do that by moving money into assets that are low risk (i.e., have the 3 hedge fund characteristics discussed earlier), are cheap to own, produce income, and have performed almost as well as gold. Such stocks would be in pipeline companies (an upcoming weekly blog topic) and food-related companies (see Table). Gold bullion has returned 8.4%/yr for the past 20 yrs vs. 10.8%/yr for the 15 food-related companies in the Table. However, the 3 low-cost “hedge” funds mentioned above (BRK-B, RGLD & USAGX) have all outperformed gold bullion, and RGLD has even outperformed the average food stock in our Table. [Note: BRK-B is a newer share class priced 1/1500th as much as the legacy share class (BRK-A) referenced in the Table.]

Bottom Line: The US economy is on the mend, and fears of hyperinflation will wane as people come to realize that interest rates can only go up a few percentage points in a slow-growth economy (“the new normal"). On the other hand, the increase in Social Security recipients will cause such a severe strain on the US government’s balance sheet in 10 yrs that hyperinflation could occur if current fiscal policies remain in place and China stops increasing its purchases of US Treasury Bonds. We think the possibility exists that interest rates could fluctuate in a frightening manner until Congress comes up with a way to meet our obligations without depending on the kindness of others. The average investor will want to protect herself with the next best thing to bonds and gold, preferably stock in stable companies that pay a good and growing dividend--which becomes something to spend in retirement. Food-related companies are among the safest and best-positioned to respond to population growth and the reduction in poverty, whether or not global warming proves to be a calamity.

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Risk Rating: 4.

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