Get Ready for Rising Prices

by David Dreman

The markets, the dollar and commodity prices have all plunged and then rebounded. Financials are still falling. Economic news both in the U.S. and abroad continues to get worse. How do you chart a course in all this? Through all the smoke, and the cacophony of distressed voices on the financial battlefield, I find several things you can sensibly do.

Before you do any of them, you need to recognize the dilemma that the Federal Reserve and the Administration find themselves in—and are powerless to resolve. As investors are painfully aware, banks, investment banking firms and Fannie Mae and Freddie Mac (which have almost become penny stocks) are still drowning in seemingly endless pools of bad mortgages. Despite ample borrowings from an indulgent Fed, banks are far less liquid than when the crisis began. As loan defaults continue, they’re going to have to write down their portfolios even more, further impairing their capital and shrinking their stock prices. They’re reaching a point where they can’t raise new funds without badly diluting current shareholders. Thus the input of new funds by the Fed hasn’t lowered rates for mortgages or raised the financial institutions’ liquidity.

Consumers are trapped by stagnant wages, depleted savings and falling house prices. They’re slipping behind on their mortgage and home loan payments, and their spending is being squeezed harder than in more than a generation. So the Fed and the Treasury have no choice but to keep interest rates low until the current liquidity problems are under control. Not to do so would result in a steep recession and the threat of a financial panic. Yet keeping rates down risks damage to the economy from the highest inflation since the 1978–81 period, when prices rose at an average of 11% a year. That’s the Fed’s dilemma.

The July Consumer Price Index was 5.6% higher than a year earlier, the Producer Price Index 9.8% higher. Import prices, thanks to a weak dollar and expensive oil, are 21.6% above a year ago, the largest one-year increase since the index began in 1982. Optimists predict that energy, raw material, commodity and import prices, the strongest forces behind rising inflation, are likely to reverse direction and drop significantly. Wishful thinking. The world is short of oil, and the appetite for it keeps growing at almost double the rate of new discoveries. There hasn’t been a year since 1984 when new finds outstripped consumption. Even if a recession slows down oil use in the U.S. and Europe, demand will still increase in China, India and the Middle East. Rapid industrialization in those regions will continue to drive up commodity prices.


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Wintergreen Fund Semi-annual Report

The last six months have been filled with volatile worldwide financial markets that have kept all investors on their toes. The apparent freefall of some securities is providing huge buying opportunities for value investors, but at the same time the daily market fluctuations are somewhat bewildering to investors as we navigate turbulent market conditions. Wintergreen Fund has been affected by this volatile market: the Fund’s performance for the first six months of 2008 was (11.86%) only slightly better than the Standard & Poor’s 500 Composite Index at (11.91%). The market has not discriminated between high-quality and low-quality companies; virtually every stock has declined. Generally, markets reward solid, stable companies, but this year even the best companies have suffered. The movement from easy credit to little or no available credit has restricted normal business operations and slowed down speculation. We believe companies with the following three characteristics are great long-term destinations for investor capital, even though the short-term quotations are less than favorable: solid businesses that generate cash; businesses with pricing power; and businesses with rational management who create value for their shareholders.

A favorite story of mine as a child was “The Little Engine That Could” by Watty Piper. In this story, a long train needed help to get over a large mountain. Various railroad engines that had the capacity to move the train refused to help. They said the job was too big and difficult for them, and the mountain was too steep. The engines that were designed to haul heavy freight would not attempt to move the huge train. Eventually a small engine that didn’t appear to have the necessary get-up-and-go was asked for assistance and that small engine agreed to try to help the large train. Using all of its power and repeating ‘I think I can, I think I can’, the small engine got the freight train up to the top of the mountain. As the train went down the tracks on the far side of the mountain to deliver toys and treats to the children who had been waiting, the little engine repeated the phrase, ‘I thought I could, I thought I could’.

In this global market that looks too big for anyone or anything to bring it back to a more stable environment, I think that solid analysis of companies and careful accumulation of underpriced stocks has the potential to yield great rewards. Like the little engine that put its head down and worked at its assignment, the pursuit of fundamental research coupled with an appreciation of the consistency of human behavior should identify the securities that I believe will survive and thrive in the future. Now is the time when some of these companies are on sale. Although no one knows precisely when, it is inevitable that these wild bargain prices will at some point in time come to a close. When that happens, and with the benefit of 20-20 hindsight, many investors will wish they had accumulated a bigger stake in these bargain companies.

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