After six years of rising stock and bond prices, there are no obvious bargains left – at least not in the places most people are looking.
The picked-over state of the investing landscape was on vivid display in the most recent forecast from GMO, the Boston money manager. The company, which has been one of the more reliable guides to the market over the past couple of decades, regularly estimates the real – that is, after-inflation – returns that can be reasonably expected from various types of investments over the seven years to come. Its latest estimates, based on values at the end of 2014, make for a sobering read.
According to GMO, large U.S. stocks are primed to lose you an average of 1.8 per cent a year in real terms between now and 2022. U.S. small caps are even uglier (an average annual loss of 2.9 per cent) while large international stocks (presumably including Canadian equities) will produce only meagre real returns of 1.3 per cent a year. Most bonds are expected to be money losers.
If GMO is right – and its forecasting record has been good, although not perfect – the coming patch is likely to rank with the 1970s as one of the most frustrating decades for investors in living memory. The trick will be finding ways to grow your wealth as interest rates begin to creep back to normal levels. Those higher rates will pull down bond prices and are likely to kneecap stock prices.
Investors looking for decent profits in this environment may have to venture into dangerous neighbourhoods. "If you are a long-term investor interested in finding bargains, my advice to you is to go where it is darkest, where micro and macro uncertainty swirl around every input and where every estimate seems like a stab in the dark," writes Aswath Damodaran, a professor of finance at New York University's Stern School of Business.
Prof. Damodaran, who writes an excellent blog, Musings on Markets, Musings on Markets, provides a few examples in recent posts of stocks that may appear tempting: Petrobras SA, Lukoil OAO and Vale SA.
All three of these stocks look dead cheap on paper, trading well below their previous highs. Two of them (Brazil's Petrobras and Russia's Lukoil) are major oil producers crushed by falling energy prices as well as more idiosyncratic risks, such as a corruption scandal (in the case of Petrobras) or Russia's growing political chaos (Lukoil). Vale, for its part, is a huge Brazilian iron and nickel producer that has suffered as commodity prices have swooned.
The three companies share many similarities, but only two are attractive buys, according to Prof. Damodaran. His analysis of Petrobras shows an enterprise that is destroying value by investing huge amounts on exploration and development while paying little attention to returns.
The root of its problem is political interference. A dual-class share structure hands effective control to Brazil's government and forces the oil producer, which was the fifth-most valuable company in the world in 2011, to make decisions that are out of touch with business reality.
"The way Petrobras has been run so defies common sense … that if I were a conspiracy theorist, I would be almost ready to buy into the notion that this is part of a diabolical plan to destroy the company hatched by evil geniuses somewhere," Prof. Damodaran says.
He sees much better value in Lukoil and Vale, although both have their own governance issues and are fundamentally tied to the outlook for unpredictable commodity prices. His analysis, done last November, suggests that both Lukoil and Vale are trading well below a reasonable appraisal of their value.
He's not backing down from that perspective, although neither stock has produced a profit since that November post. As he points out, there is lots of uncontrollable risk in both companies – and that's precisely why they are bargains.
Of course, many investors will conclude, with good reason, that such "bargains" are way too hazardous for their portfolios. But if GMO is right, people who want more than lacklustre returns in the years ahead will have little choice but to take on more risk.