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Food for Thought

Reflections from the 2012 Morningstar Investment Conference.

Since we wrapped up our Morningstar Investment Conference this past week, I've found it hard to focus on day-to-day duties. Instead, I'm mulling over what questions to explore or what actions to consider for my family's investment plan. Here are a few thoughts, based on hearing from a number of ace managers across multiple asset classes during the conference.

Greece Matters but Will Matter More Later
Templeton's fixed-income czar Michael Hasenstab kicked off the conference with his take on the European drama, as everyone is wondering whether Greece will stay in the eurozone. In his view, a Greek exit would be strong medicine--bitter in the short term, helpful in the longer term--and dangerous only if market panic struck Italy or Spain. Spain, he argues, has more wiggle room than Italy to navigate that environment, but substantial and likely contentious labor reforms would be essential to getting both countries back on track. On a related note, Loomis Sayles' Dan Fuss raised the possibility that the situation could turn into a geopolitical powder keg if Greece leaves the European Union or if competition for the region's energy reserves heats up.

The European Central Bank ostensibly has loads of cash to cushion any blows, but, in hearing from a number of fixed-income experts during the conference, it appears that the European debt crisis will be with us for a decade or more. That means fixed-income investors ought to brace for volatility and embrace bonds with strong fundamentals and relatively attractive valuations. That could include sovereign debt backed by healthy economies and credible governments such as South Korea and Malaysia (featured prominently in Hasenstab's  Templeton Global Total Return (TGTRX)) or corporate debt issued by "rising stars."

That latter bucket, representing corporate-bond issuers poised for a credit-rating upgrade, is favored by Mark Kiesel, lead manager on  PIMCO Investment Grade Corporate Bond (PBDAX). Sounding like an equity fund manager, Kiesel emphasized the importance of focusing on pockets of growth within a low-growth environment. Asian gaming and energy figured high on his list, energy being one area where investors may find both the equity and the debt attractive. He also believes that companies owning natural resources or "real assets" (such as timber producer  Weyerhauser (WY)) are attractive because of very long-term increasing demand for commodities of all kinds.

While Greece is hogging the headlines, the real trouble brewing is in U.S. Treasuries, where negative real yields are already here and the potential for capital loss is growing. Should various rescue efforts and artificially depressed rates actually prove successful in assuaging markets and nudging investors into riskier assets, a broad shift in investor sentiment or slightly higher rates could deliver an unexpectedly harsh blow. Steve Romick from  FPA Crescent (FPACX) and the University of Michigan's William James Adams both noted the United States' current interest payments account for 6% of gross domestic product. With roughly 40% of U.S. Treasuries set to expire by 2013-2014, even slightly higher rates could push the interest burden to north of 15%-20% of GDP, a threshold that historically has triggered a mix of severe economic consequences, social unrest, or sharp inflation in countries unfortunate enough to cross it. Maybe this time will be different, but I doubt it, and I'm thinking of how to prepare for that chain of events.

Stocks Are Bonds, and Cash Is in the Eye of the Beholder
Presenting alongside Mark Kiesel were Meggan Walsh of  Invesco Diversified Dividend (LCEAX) and Don Yacktman of  Yacktman (YACKX) and  Yacktman Focused (YAFFX), two equity managers who sounded a lot like bond managers. I had an "aha" moment when I asked Yacktman if we should consider stocks as bonds in light of today's minuscule bond yields, and he responded, "How could you not?" He and Walsh view stocks as claims on future cash flows--that sounds like a bond to me--and take precautions to home in on those most likely to deliver those cash flows.

Specifically, that means they seek companies whose returns on invested capital exceed their cost of capital (a key component of Morningstar's Economic Moat Rating for Stocks) and those who generate more than enough cash to make their debt payments. For both Yacktman and Walsh recently, this has meant big chunks of consumer staples stocks like  Procter & Gamble (PG) and  Sysco (SYY). Dan Fuss, a driving force behind  Loomis Sayles Bond (LSBRX) and  Loomis Sayles Strategic Income (NEFZX), is playing a variation on that theme, favoring issuers such as  Intel (INTC) whose superior profitability could give them a leg up should higher borrowing costs down the line put the pinch on lesser rivals.

Fuss and Yacktman are similar in that they have been holding double-digit stakes in cash and cash equivalents as ballast and dry powder to snap up opportunities should the markets lurch downward. Cash was discussed quite a bit during the conference, in the Fuss/Yacktman vein, as a point of reference for liquidity needs, and in the (to me) quixotic search for cashlike assets that yield more than actual cash. My take-away was the notion that raising cash (held in a dirt-cheap money market account) in order to scoop up beaten-down wide-moat stocks and energy companies or others owning "stuff in the ground" is a good idea at this point.

Ask Me in 30 Years Whether Owning "Stuff in the Ground" Made Sense
Regarding real assets (aka "stuff in the ground") GMO's Jeremy Grantham delivered a sobering keynote speech touching on resource scarcity and the very long-term effects of consumption growth in emerging markets such as China and India. In April and July 2011, he and GMO authored two seminal papers on those topics, titled "Time to Wake Up: Days of Abundant Resources and Falling Prices are Over Forever" and "Resource Limitations 2: Separating the Dangerous from the Merely Serious." (Visitors can register on the GMO website, click on the Library tab, then click on "Jeremy Grantham's Letters and Articles"). Both papers ought to be mandatory reading for anyone working in finance, business, engineering, education, law, or public policy--you get the drift.

Grantham has taken a page out of Garrett Hardin's "Tragedy of the Commons" and uses historical data and relatively straightforward math to support the argument that a number of commodities--primarily metals, inputs for making fertilizer, and water--are finite, not replicable, and depleting quickly in the face of growing consumption. That consumption, he argues, will drive prices of commodities and real assets upward over coming decades, as a greater number of the world's population increase energy and food consumption. The upward price trend wouldn't be a smooth one, as the usual boom-and-bust ride of commodities is likely to become even more volatile because of periodic shortages.

Even so, for folks like me who will likely be working for another 25-30 years, the idea of beginning to build a position in real assets, adding to it when prices crater, and tuning out the volatility is one I'm thinking about seriously. I'm not yet sure whether to do so through a basket of stocks, using sector funds such as  Vanguard Energy (VGENX) or iShares S&P Global Timber & Forestry Index (WOOD), or using a broader offering such as Hartford Global Real Asset (HRLAX). That decision will likely come down to whether I choose to commit the time necessary to monitor a stock basket or whether adding a dedicated fund would result in too much overlap with my existing holdings. I also need to think more about sizing because I've seen suggested allocations to real assets range from 5%-25% or more; that wide range means I need to do more homework.

My take-aways from the conference led to a to-do list that ought to keep the summer lively: Minimize exposure to U.S. Treasuries, build up some cash, sort through a real assets allocation, and, among equities, keep an eye out for cheap stalwarts. That list is based on my own financial situation, and I'd suspect that other conference attendees' take-aways vary widely given theirs. My favorite aspect of the conference is that it's both a barometer and a good time for a portfolio checkup. I'm already looking forward to next year's--we hope to see many of you there!

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