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The Deep Value Investing Philosophy During The Fed’s Ongoing War On Deflation

The definition of inflation is a general increase in the price levels for goods and services. Deflation is simply the opposite of inflation, where prices are declinin g, not rising. The Federal Reserve (Fed) is of the belief that targeting inflation at a rate of two percent is the optimal level for keeping the United States (U.S.) economy chugging along. Let’s compartmentalize for a moment whether the Fed is even measuring the true rate of inflation correctly. Taken from the Fed’s website , “Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.” Former Federal Reserve Chairman Ben Bernanke had a religious devotion to the “inflation good, deflation bad” mentality as indicated by his academic work. Bernanke’s collection of research papers blame the Fed in the 1930s for not increasing the money supply to fight off deflation so as to avoid the Great Depression. Determined not to repeat the same mistake during the crisis in 2008, Bernanke aggressively implemented a quantitative easing program while simultaneously hammering interest rates to the floor. No monetary tool at the Fed remained idle in order to avoid deflation and the perceived risk that falling prices result in a collapsing economy. ​Looking at deflation from more of a bird’s eye view rather than simply looking at Bernanke’s favorite example of the 1930s Great Depression, a different conclusion might be reached regarding falling prices’ perceived linkage to a contracting economy. A previous study showed no connection between deflation and a depressed state in the overall economy. The study looked at more than 100 years of economic data spread out over 17 different countries. No correlation existed between deflation and a contracting economy across all international markets , including the U.S. Even when the microscope was put over the 1929-1934 deflationary period, half of the countries in the study experienced economic growth despite collapsing prices. There does not appear to be compelling evidence that the Fed adds value to the economy by targeting a particular inflation rate in order to avoid the scourge of deflation. As I mentioned in a previous blog , successful entrepreneurs focus on their own individual businesses. Monitoring macroeconomic variables as they do at the Fed is not a productive use of an entrepreneur’s time. Individual investors should have the same mentality when it comes to their portfolios. Rather than guessing the future rate of inflation and what effect it might have on financial assets, investors should focus on the minutiae of which stocks and bonds are of good value to purchase. Sliding the macroeconomic textbooks in a drawer and focusing on what stocks trade at a price point below some measure of intrinsic value is the behavior pattern of successful investors. One de minimis estimate of intrinsic value applied to a stock is its net current asset value calculation. The chart below shows the average annual return following the rigorous value investing criterion of purchasing only stocks trading below net current asset value. The performance results are independent of Fed policy and do not require an investor to have an opinion on the future rate of inflation. *Net Current Asset Value Portfolio has no more than a five percent weighting in any one stock. Dividends and transaction fees are included in all of the calculations. During years where few stocks could be found, funds remained idle in U.S. Treasury Bills.​ That subset of the Fed hierarchy who serve on the Federal Reserve Open Market Committee (FOMC) spend their days analyzing changes in various macroeconomic indicators, looking for clues as to the direction in which the overall economy might be headed. The FOMC is the primary decision-maker as to where short-term interest rates should be targeted. As already mentioned, its attempt at targeting the inflation rate is not consistent with statistical evidence in terms of stimulating the overall economy. Pushing interest rates to the floor in order to target a two percent inflation rate has resulted in retirees’ receiving little to no interest on their savings. This zero interest rate policy (ZIRP) has been in effect by the FOMC over the past 84 months. Unfortunately, an individual investor cannot control the behavior of the masterminds at the FOMC, but he or she can control what stocks to include in a portfolio. As indicated on the chart, embracing a deep value investing philosophy by purchasing only stocks trading below net current asset value outperforms the broad market average over the long term. This holds true both before and after the FOMC scrapes its targeted interest rate off of the floor. It is a peculiar financial world we currently live in. The FOMC pores over the changes in food, clothing, and energy prices purchased by consumers. These prices are manipulated by the Fed, forced to move in a direction that may be in conflict with where Mr. Market feels they should be headed. Over the past seven years, entrepreneurs in this country have been manipulated into misallocating resources via the forced feeding of ZIRP soup by the FOMC. Because of their low interest rate policy, the Fed’s mandate of seeking long-run employment and price stability has morphed into an orgy of enticing reckless speculation with regard to overpriced stocks. Getting paid to manipulate interest rates and blocking a clear view of honest price discovery in stocks seems to be a waste of taxpayer money and a major irritation to investors who embrace a strict value investing philosophy.

Drilling Down For Bargains After Oil’s Decline

Stocks have suffered lately, with year-to-date returns for U.S. equities once again negative . The most recent driver of the selloff , and accompanying volatility, hasn’t been fears of a Federal Reserve (Fed) rate hike, but rather collapsing oil prices and the implications for energy-related debt. Paying less at the pump might seem like a good thing for consumers, but the recent drop in crude prices has reinforced fears over slow economic growth and deflation, placing pressure on a range of asset classes related to energy . According to Bloomberg data, amid concerns over energy issuers in the high-yield market , high-yield spreads continued to widen last week. The fall in oil is also putting more pressure on already battered emerging market oil exporting currencies , including those of Mexico, Russia and Columbia. Finally, and not surprisingly, any company in the energy space is feeling pressure. This includes not only oil production and service stocks, but also Master Limited Partnerships (MLPs). However, while market sentiment has certainly turned more negative lately, many investors are wondering if it’s time to start bottom fishing, especially with regards to beaten-up energy assets. Considerations for Energy Sector Stocks My take: Though I would remain cautious toward the commodity and believe energy-related names are likely to come under more short-term pressure, I do see longer-term opportunities for those with little or no exposure to energy stocks. The near-term risk for investors is that, regardless of the particulars of the business model, any stock even tangentially related to oil or energy is being thrashed. This is likely to continue to the extent oil prices have more downside. In fact, given the abundance of supply and bulging inventories, I’d be hesitant to call a bottom in oil prices. While I believe that oil supply and demand will start to balance toward the middle of next year, absent a supply disruption from the Middle East or a much sharper deceleration in U.S. production, the simple truth is that there’s still too much oil supply relative to demand. The outlook for Middle East supply remains undimmed, despite growing geopolitical risks. The Organization of the Petroleum Exporting Countries (OPEC) is unable to even set a production target , and Saudi Arabia and Iraq are producing record amounts of oil. Even a country like Libya, with no functioning national government, has dramatically increased production in recent months. Making matters worse, non-OPEC oil production has remained resilient. In an attempt to generate much needed revenue, Russia is pumping a record amount of oil. In the U.S., while production has pulled back from the spring peak, production cuts have been modest thanks to improving efficiency. The number of U.S. rigs is down more than 60 percent from its 2014 peak, but U.S. domestic production is off by less than 5 percent, according to data accessible via Bloomberg. Nor is a surge in demand likely to quickly rescue oil markets. For 2016, global demand growth is estimated to fall to 1.2 million barrels per day (bpd) from 1.8 million bpd this year, as data via Bloomberg show. It will take time to balance out oil markets, assuming we don’t see a more meaningful disruption in supply or a spike in demand, which is unlikely given the sluggish pace of global growth. However, while an imminent V-shaped recovery in physical oil looks unlikely, some of the stocks in this sector may still represent a good long-term opportunity, especially considering that energy-sector valuations are now the cheapest we’ve seen in decades, according to data accessible via Bloomberg. There are two places in particular investors underweight the energy sector may want to start looking to add positions: U.S. drillers levered to low cost production sites and midstream MLPs. 1. U.S. DRILLERS LEVERED TO LOW COST PRODUCTION SITES The cratering in oil prices is hurting any and all energy companies, but I believe those with lower production costs, such as Exploration & Production companies focused in the Permian Basin in west Texas, are better positioned to ride out a period of depressed oil prices. 2. MIDSTREAM MLPS While MLPs aren’t immune to the energy market, as evidenced by the recent 75 percent dividend cut by Kinder Morgan, many MLP businesses are focused on natural gas storage and pipelines. These midstream businesses are less exposed to the daily fluctuation in oil prices. The bottom line: While the energy sector comes with considerable near-term downside, the key for the long term is selectivity and a focus on those names best positioned to survive, or even thrive, in what may be a prolonged period of low energy prices. This post originally appeared on the BlackRock Blog.