Weighing The Risks of Investing In Today’s “Hot” Sectors

By Elmer (Al) Meszaros, CFA, Partner

In particular, many analysts and pundits warned of an imminent collapse—or bubble burst—in the prices of residential real estate.

Besides residential housing, valuation data suggested other sectors where “bubbles” exist:

• Real estate investment trusts (REITs);

• Energy stocks;

• Utility stocks.

All are selling at very stretched valuations, compared to historical valuation medians. In addition, many energy companies, especially large integrated oil producers and refiners, are experiencing profitability levels nearly twice historical levels. Exxon Mobil and Chevron recently registered 30% returns on equity—a level we believe is unsustainable.

Table I (on page 2) shows a specific example of what I mean. Oil company profitability has been driven by the doubling of the price of the underlying commodity, oil. However, oil prices can be extremely volatile, collapsing three times in the past 20 years by 43% to 63%.

The fastest collapse occurred in December 1985, as Lee R. Raymond, Chairman and CEO of Exxon Mobil Corporation, recently reminded the public. Raymond recalled that oil prices declined 63% in two just weeks—from $27 a barrel to $10 a barrel—after some people had predicted the price of oil would hit $100 a barrel.

Two years ago, oil stocks were modestly attractive. But at today’s high price levels, the investment risks are meaningfully higher.

Reasons for concern

Investors’ money often pours into a sector at the peak of a bubble. Thus, hedge fund assets have doubled in five years, despite lackluster results in 2004-2005.

Real estate speculation has increased as the National Real Estate Investors Association reports a doubling of members in one year to 20,000, as home prices soared in some parts of the country.

In the energy sector, 12 natural resource mutual funds have been rolled out since the beginning of 2005, reminiscent of major internet technology funds launched near the March 2000 peak.

Index Funds

Some people think that “index” mutual funds offer a viable means to capture profits from all segments of the stock market with relative safety. In reality, however, most index funds actually capture ALL of the bubble (that is, overvalued) sectors of the market, thus explaining how the bursting of the technology bubble of 2000 drove the 48% decline in the S&P 500 Index over a 33-month period.

Of course, there are always reasons to say “this time it’s different.” But most of the time, stretched conditions do revert to the mean.

Warren Buffet, arguably the world’s most successful investor, has often expounded on the importance of avoiding losses as the key to long-term success. Avoiding “bubble” risks is in line with that strategy.

Risk-averse strategy

We recently studied the performance of client portfolios over the past five years (see Table II below).

While past performance is no guarantee of future results, we found that in the months that the S&P 500 or Russell Top 200® Indices were down, the composite performance of our clients’ portfolios actually outperformed each index 80% of the time. This underscores the effectiveness of a risk-averse strategy that focuses first on preserving capital, positioning portfolios to perform well over an entire market cycle.

It’s not clear if any of these bubble sectors we’ve addressed will end in collapse or merely under-perform as overvaluations revert to the mean. But, we do know that the risks have increased. And so, we prefer to invest for our clients and ourselves, in areas where the reward/risk ratio is in our favor.

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If investment “bubble bursts” had a negative impact on your portfolio over the past few years, now is an ideal time to switch your assets to Midwest Investment Management and start enjoying the benefits our highly disciplined approach to long-term investing can provide. To get started, simply contact Al Meszaros at (216) 830-1133 or e-mail: elm@mimllc.com