Four Predictions

Successful investing is all about trying to predict the future. It is also a matter of percentages; one can be a very profitable investor if only correct 55% of the time, as long as one does not get hurt too badly on the calls that are off the mark. Being right just 55% of the time may seem like an easy hurdle to surpass, but in the complex system that comprises our economy and markets, seeing the future is anything but easy.

This will not stop me from taking a stab at how I see certain situations playing out over the next year, informed by research completed by our large equity analyst staff at Morningstar. In the February issue of StockInvestor, I made ten predictions; here are four of them. This time next year, I will look back and see how prescient I was. Without further delay ...

1) Housing Prices Will Rise in 2011
A housing bubble of historic proportions was one of the key factors that led to the Great Recession, and we entered the credit crisis with a large excess of homes after years of over-investment. However, the crisis started in 2008, and it is now 2011. We've had nearly three years where home construction has been in deep hibernation--with housing starts running at an annual rate of roughly 500,000 to 700,000 units, about one third the rate mid-decade, and barely enough to keep up with removals from disaster and obsolescence. However, the population of the country only continues to grow, and new household formation should run at a normalized rate of about 1.4 million per year. Household formations were well below trend during the recession--only about 0.4 million--because one generally needs a full-time job to leave the nest and form a household. However, formations should normalize as the economy heals and should even provide a source of latent demand.

Regardless, with housing affordability (prospective mortgage payment as percentage of household income) near an all-time best level and with excess inventory well on its way to being burned off, I think housing prices will rise modestly in 2011. Barring an unexpected change in the economy, I also think they will rebound very significantly in 2012. I will measure myself using the Case-Shiller housing price indexes. Moreover, I will make a secondary, related prediction that the phrase "housing shortage" will increase at least 50% in search frequency on Google (GOOG) by this time next year.

My currently bullish view on housing is one of the reasons I continue to own Home Depot (HD) and Lowe's (LOW) as well as St. Joe (JOE). Another, more opportunistic pick (economic moat rating of none) that our analysts are pounding the table about is building products maker Masco (MAS).

2) Automotive Demand Will Continue to Rebound Significantly
During much of the last decade before the recession, auto sales in the U.S. ran at roughly 17 million units per year. Sales then cratered to a rate less than 10 million units per year at the height of the crisis. However, the recession did not change the fact that vehicles crash and wear out. There is also a new crop of teenage drivers every year helping to increase the number of licensed drivers in the country. Between the economy recovering and the latent demand created by the recession, I think new auto sales will go from 11.6 million units in 2010 to close to 15 million in 2011 and perhaps peak near 18 million units by 2012. Among companies I own in StockInvestor's model portfolios, tight inventories and rising used-car prices will continue to be a tailwind for CarMax (KMX), but 3M (MMM) and Fastenal (FAST) also have some exposure to the automotive industry.

3) Agriculture Will Remain Hot
Back in mid-2008, anything related to agriculture was in a raging bull market, but then the credit crisis curtailed demand and took the bloom off the rose. Recently, the factors behind the bull market came back with a vengeance, helped along by a lack of investment during the recession and other factors like droughts in Eastern Europe and floods in Australia. Most agricultural commodities--corn, wheat, soybeans, etc.--have prices up 50% to 100% during the last nine months and are near peaks reached in 2008. High food prices are largely behind much of the recent unrest in the Middle East; food is not a huge part of most household budgets in developed economies, usually just over 10%, but it is near 50% in many emerging markets.

I don't think the upward pressures on these commodity prices will cease anytime soon. The world population only continues to expand, the rising affluence in emerging economies is causing consumption to rise at a rate greater than overall population growth (especially with the rising consumption of meat, which has a multiplier effect), and the amount of arable land on the planet is not materially growing. Plus, inventories of agricultural commodities are forecast to be near all-time lows later this year, and we've seen early signals of hoarding, which could exacerbate the situation. My educated guess is that the CRB Continuous Commodity Index stays near a peak, if not rising higher. We have exposure in the Hare Portfolio to this "agflation" through our ownership of Compass Minerals (CMP), which has a meaningful specialty fertilizer business. Meanwhile, I'm still kicking myself for not picking up PotashCorp (POT) a year ago.

4) Health Care Will Be One of the Best Performing Sectors
The health-care sector had the worst performing stocks in 2010, thanks largely to a "fear, uncertainty, doubt" overhang created by the reform legislation signed into law early in the year. Many in the market appear to have thrown up their hands in frustration, but we at Morningstar think that the reform legislation will actually be a mild net positive for the sector--whatever these companies give up in terms of higher taxes and lower prices forced by reduced government reimbursements will be more than offset by higher volumes. After all, we could have upwards of 15% more Americans--just over 50 million--with health insurance with the new law. Looking at the median price-to-fair value estimate ratios of the sectors, health care remains one of the most attractive at 0.94 versus 1.03 for our coverage universe as a whole. I'm not certain health care will be the absolute best sector in the year ahead, but I'll call this prediction a success if it is in the top three.

Pfizer (PFE) remains my favorite opportunity from this sector at the moment, trading at roughly 9 times estimated 2012 earnings, which is the first full year after the company's Lipitor patent expires. Abbott Laboratories (ABT) also is looking quite attractive, trading at a very low multiple of earnings despite executing quite well in recent periods. Among other health-care stocks I own in StockInvestor's Tortoise Portfolio, Novartis (NVS) and Johnson & Johnson (JNJ) have lost some of their luster (especially J&J) and are no longer priced at dirt-cheap levels, but they remain relatively solid businesses with moderately attractive valuations on their stocks.

So there you have it, (at least) four predictions. Never let it be said that I'm not afraid to occasionally go out on a limb or two. It should be an interesting year ahead. If you'd like to see the rest of my predictions, give StockInvestor a spin.

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