Problem areas breed opportunity

CIO Insights 2Q2008

For devoted value investors, the current market situation is rather exciting. We believe that we are being offered decent investment opportunities at attractive prices, mainly in the following areas:

First, select companies in industries whose margins get temporarily squeezed by rising input costs (chemicals, packaging and food, among others). With a time lag, the shrewd competitors in this space typically find ways to apply stringent cost control and/or adjust pricing to a level that will restore, or at least approach, historic margins.

Second, select companies experiencing cyclical weakness triggered by the macro-economic slowdown (e.g., machinery, engineering services, commercial services). For the investor who is willing to look patiently over the course of an entire cycle, as we are, some businesses now appear too cheap given their entrenched market positions and healthy balance sheets.

Third, select companies in industries facing structural issues that require a fundamental transformation in strategy and execution (e.g., traditional media, advertising services, basic materials, certain utility services). Here, the market now and then tends to overdiscount the value of legacy-burdened incumbents while placing heavy bets on newcomers with a clean slate. Taking history as a guide, sometimes the “late-mover” advantage by an opportunistic, deep-pocketed incumbent may in the end carry home the win against the perceived agility by an aggressive new entrant.

Last but not least, at these prices we also like select owners of land (forestry, agriculture, real estate). These equities have sold off due to the slump in real estate finance. However, we believe that their long-term benefits as inflation-protected assets far outweigh those shorter-term concerns.

We continue to avoid hard-to-assess areas where there may be a lot of opportunity but, along with it, a great danger to step into “value traps.” Fearing to make too many mistakes, we’d rather stay away from sectors including big pharma, finance and retail. Furthermore, we are also underexposed to the energy and mining complex, which has become too pricey for us.

Sincerely,