What Looks 'Good and Cheap' Today?

Noted author William Bernstein is a strategic asset allocator. But he periodically becomes intrigued by asset classes when they get what he calls "good and cheap." Morningstar director of personal finance Christine Benz recently talked with Bernstein about opportunities in some of the beaten-down parts of the market. Below is an excerpt from that conversation.

Christine Benz: When you and I talked a year ago, you were enthusing about precious-metals equities being relatively cheap. They've arguably gotten a little cheaper since then. What do you think about precious-metals equities today?

William Bernstein: They've gotten a lot cheaper since then. So if I was interested back then, I'm very interested in them right now. I have always believed that a small percentage of any diversified portfolio should be dedicated to precious-metals equities. Not an essential piece, but certainly if you want to entertain that sort of complexity in your portfolio, these stocks are quite reasonable in the range of 1% to 5% of your portfolio.

Benz: What role do they play in a strategic asset allocation?

Bernstein: You can look at it from two perspectives. One is the simple mean-variance perspective, which is that when you add in 1% to 5% of precious-metals equity to a normal portfolio--in normal times at least--you get a bit of a bump in return and you get a bit of a reduction in risk. What are you protecting against? You are obviously in a more heuristic sense protecting against inflation.

Benz: When you look at precious-metals equities from a bottom-up standpoint, what appears attractive about them?

Bernstein: It's very difficult to value precious-metals equities because some of them sell a lot of forward contracts and their earnings are very, very unstable. Really, the only thing you can follow that has any real meaning, I suppose, is their dividend yield. And you can now find precious-metals stocks fairly easily selling at a 1% and 2% trailing dividend. Although that doesn't sound like much, for precious-metals equities, it's quite high.

That brings up another subject about precious-metals equity that you have to understand, which is that over the long term, its return is very low--probably no more than 1% to 2%. And that's probably all from the dividend. The reason why it's so expensive and has such a low return and has such a low dividend yield is simply because it is such a good diversifying asset class. People recognize that, and they overbid the price, if you will.

Benz: You prefer precious-metals equities versus owning gold bullion. Why?

Bernstein:

It's because you need a whole lot less of it. It's basically a leveraged bet on gold, and I'd rather own 3%, say, of precious-metals equity rather than have to own, say, 15% or 20% of a commodities-futures fund or of something like

Read More: Precious-Metals Equities: A Pocket of Cheapness in a Fairly Valued Market?

Benz: Moving on to another category of unloved investments, let's talk about emerging-markets equities. Are they good and cheap today?

Bernstein: They are cheap; they are not good and cheap. They are certainly not as cheap as they were during the wake of the Asian contagion. What I'm fond of saying about emerging markets is that the really nice thing about them is they really do get good and cheap from time to time. It's important for small investors to realize that you can't buy low unless you are willing to deal with bad news. Stocks don't get cheap and prices don't get low without bad news, and you have to be able to ignore the bad news.

Read More: Morningstar's Favorite Emerging-Markets Funds and ETFs

Benz: Another category of investments that has been beaten down and would certainly be considered unloved is energy equities.

Bernstein: They are getting interesting and, for all I know, we've seen the bottom--I have no way of predicting that. In general, the oil stocks aren't an asset class I have to own; but when they get to be compellingly cheap, I become interested. When you start seeing the majors selling at single-digit trailing multiples, they become of interest. We're not there yet.

Read More: Energy: No Rapid Rebound for Oil Prices

Benz: When investors hear smart people like you talking about the relative valuations of asset classes, how should they use that information?

Bernstein: The first thing you have to ask is whether you are cut out to do it. Because in order to be cut out to do it, you have to be able to be greedy when everyone else is fearful--and fearful when everyone else is greedy. You have to be able to increase your allocation to an asset class when it has been very badly beaten down.

Let's say you typically have a 2% allocation to precious-metals equity. To maintain that 2% position, you have had to continually be buying over the past two or three years. And if you wanted to more strategically allocate, you would have been plowing even more money into it to increase your allocation as it was getting cheaper.

You have to also ask yourself the question, "Do I really want to go through the trouble?" Because the data shows that it's hard to beat a regular old 60/40 stock/bond portfolio with a fixed allocation between foreign and domestic asset classes within your stock allocation. It's really, really hard to beat that.