How to Cash In on Sovereign Wealth Funds

The early 21st century is being marked by the rise of a new player on the financial landscape: the Sovereign Wealth Fund, or "SWF". Nations with large surpluses of dollars from petroleum exports or manufacturing - think China, Dubai and Abu Dhabi - are no longer content to park their dollar reserves in bonds that offer paltry returns below the rate of inflation. Instead, they are using an increasing portion of their reserves to create Sovereign Wealth Funds, pools of money which use the money endowed to them to make investments in stocks and other assets with the potential to provide substantial returns over the long term.

So, why should you care? The most important reason that you should care about this development is that understanding how sovereign wealth funds are investing their money can help you to you can position yourself to benefit from their buying spree. At the most basic level, sovereign wealth funds provide investors with reason to be at least moderately bullish because purchases of equities by these funds will help to prop up stock prices in coming years as streams of money that previously flooded into bonds in recent years adds to demand for stocks.

The Housing Boom that China (Partially) Built

Before we begin projecting into the future, we should probably review the recent past. Although the recent boom and bust in house prices was largely attributed to moves by the Federal Reserve, that was not the only factor that contributed to low mortgage rates. Mortgage rates were also kept low by low yields on US government bonds, which compete with mortgages for fixed-income investment dollars. Many of those fixed-income investment dollars originated in China, but Saudi Arabia, Dubai and Abu Dhabi also parked much of their dollar reserves in treasury bonds; all of which helped to keep treasury yields, as well as residential mortgage rates, low. These low mortgage rates contributed to the real estate boom of recent years. However, the recent drop in the dollar, along with the dropping value of those treasury bills, has prompted sovereign wealth funds to look beyond fixed-income investments to investments in other asset classes, including equities.

Why Shares, Rather than Companies?

Sovereign wealth funds have good reason to buy shares in US companies rather than attempt to buy US companies outright. A takeover of a US company by a foreign company tends to raise protectionist ire, as we saw recently with the attempted CNOOC takeover of Unical, or with the attempt by Dubai Ports World to purchase a domestic manager of US ports. In both cases these takeovers where opposed in the media and in the US congress. Recent purchases by sovereign wealth funds of shares in US companies such as Citigroup, AMD, and Nasdaq Stock Market Inc., on the other hand, does not inflame protectionist sentiment.

This is good news for investors because the effect of sovereign wealth funds taking minority stakes in US companies is to bid up the prices of many companies that are components of the Standard and Poor's 500 and other stock indices. Because many individual investors have the lion's share of their retirement funds parked in index funds, this will benefit individual investors far more than a SWF buying spree in which companies are bought out entirely. A buyout of an individual company has little effect on a stock index, and shuts out individual investors from participating in a company's success in the future.

So, you can sit back and benefit from this trend without lifting a finger. But if you really want to benefit from the rise of sovereign wealth funds, you have some great opportunities to do so. In this post, we’ll look at a company that is working with a specific sovereign wealth fund to manage its purchases, and make the case for buying shares in that company.

Beijing via Baltimore

In late 2006, the National Council for Social Security Fund (SSF) of the People’s Republic of China selected T Rowe Price to manage its investments in US stocks. This creates a steady inflow of capital into the Baltimore, Maryland-based operator of mutual funds and provider of investment management services at a time when other asset managers are dealing with a slowdown in mutual fund purchases by consumers. T Rowe Price was a well-managed company and a good long-term investment before it was selected to manage capital for China’s sovereign wealth fund, but this additional business makes it an even better investment.

In my next post, I will discuss another strategy to cashing in on the actions of sovereign wealth funds: buying shares in the companies that these funds are buying.

Thoughts on Visiting Palm Springs

I recently visited Palm Springs, California, on vacation. I have to admit that I was shocked by the extent to which the current real-estate crisis is impacting this area. I live in western Washington State, where house prices have held up pretty well in the last year compared to the rest of the country; so I was not prepared for what I would see when I visited Palm Springs: A real-estate market in serious trouble.

For the first few days of our vacation, my wife and I stayed in a rented timeshare in Indio, just outside of Palm Springs. This timeshare was newly built, and was part of a development that included a golf course and some very recently built houses. Upon entering this development, I could not help but notice a large sign that read: "New Single-Story Homes from the Low $200s". Something looked strange about the sign, so I slowed down to take a closer look; at which point I noticed that the "2" in "$200s" was a sticker that was starting to peel, revealing a "3" beneath it. That the developer was dropping their asking prices was no surprise, but that they would drop their prices by so much, and use such a tacky sticker to change their advertising was a bit of a shock. And even at these lower prices, the neighborhood looked to be about 30% vacant.

The next shock came when I noticed several billboards carrying the following stern warning: Stealing Copper Pipes Will Land You Behind Bars. I had read about problems with theft of copper pipes from vacant new-construction houses in various national newspapers, but this was the first time that I had visited an area where copper theft was enough of a problem to warrant billboards to warn against it. This is certainly a sign of the times, demonstrating how the confluence of rising commodity prices and falling house prices have combined to create a situation where the copper in a house is the most valuable (and certainly the most liquid) part of that house.

The final detail that I noticed in Palm Springs was just how many of the retail spaces were vacant. In some cases you would see vacant storefronts or restaurants on major streets next to thriving businesses; in other cases I found entire new construction strip mall developments without a single tennant. This demonstrates that what started as a downturn in housing is rippling into a a downturn consumer spending and commercial real estate, at least in areas as hard-hit as Palm Springs.

A Better Alternative to Timeshares: Vacation REITs

OK, so you want to buy a timeshare or a vacation property. Why? Because on your travels you have fallen in love with a particular city, or a particular climate. That's perfectly natural. But before you take the plunge, you should consider some of the drawbacks of timeshares and vacation properties. And you should consider using Real Estate Investment Trusts (or REITs) as an alternative to investing in vacation property, and as a way to fund annual vacations.

The Ugly Truth About Timeshares

What makes a REIT better than a timeshare? For one, timeshares are generally overpriced by at least 50% when they are sold to the public. Think about it: who pays for all of those "free vacations" offered to people who agree to sit through a pitch for a time share? The people who actually purchase the timeshares after hearing the pitch, usually taking on loans at high interest rates to do so. As an investor, I don't want to buy anything that somebody is working that hard to sell me, and I certainly don't want to pay for the free vacations enjoyed by the people who walk out of timeshare presentations early. If you need further proof, you have only to peruse sites that sell used timeshares, such as craigslist.org. Today I logged on and found an unused timeshare within seconds that was purchased for $1800, offered for $8000 (44% of sale price). This was not a recent posting; it was over a month old. All of which means that you cannot count on selling a timeshare quickly if you need the money, even if you are selling at a deep discount to what you paid. The advantages of being able to stay at a variety of locations are hardly offset by the fees ($700 per year in this case) and the puny returns that timeshares offer their investors.

Vacation Properties have Problems, Too

Vacation properties can be better than timeshares, but they have their own problems. If you rent them out, you will likely experience some of the unpleasantness that I did during my life as a landlord. And unless you have a lot of money to invest, you will have to rent your vacation property out to pay the mortgage, property taxes, and maintenance. And if you sour on the location that you choose for your vacation property, you will have to pay comissions to get rid of it. And did I mention that many vacation properties are in tropical areas which are occasionally damaged by hurricaines?

Is this sounding like fun, yet?

An Alternative: The "Vacation REIT"

I've spent some time pointing out the drawbacks of both timeshares and vacation properties, so now I will tell you what you should buy instead: REITs, specifically REIT Indexes. REITs are shares of companies that own and manage rental properties, and that are required to pass on 80% of their profits as dividends. The Vanguard REIT ETF, an index of REITs, has a yeild of 7% as of this writing. However, given the ongoing problems in the housing and credit markets, it is very likely that we will see this yeild increase to 10% before the drop in real estate prices is over. That is when I will start buying, and when you should consider buying some REIT Index shares as well.

What this all means is that instead of buying a timeshare, or tying up all of your money in a vacation property, you can buy an asset which will track real estate prices over time and that will put money in your pocket which you can spend to vacation anywhere that you wish, if that his how you want to spend it.

Ask yourself: would you rather pay $18,000 for an illiquid, overpriced, timeshare that costs you $700 per year to own; or $18,000 for a few hundred shares of a REIT index that pays you $1800 each year, which you can spend (if you wish) vacationing in a different location each year, and which you can sell in seconds?

Their Stumble, Your Opportunity: Investing in Growth Stocks When They Stumble

Some call it a bear market. Some call it a 'correction'. Regardless of what you call it; periods of dropping stock prices, such as the one that we are experiencing right now, mean pain for investors. If you did your homework and stuck to shares of great businesses selling at great prices, then you're probably experiencing less pain than other investors; but you are still feeling the hurt.

But you are not alone in your pain, and you don't have to miss the opportunities offered by the current market malaise. Companies that are transitioning from one phase of their development to the next are being punished unfairly by the market right now, and that means that some great businesses are not just on sale, they are in the bargin-bin.

The Not-So-Secret Lives of Companies

Like people, companies go through different phases in their lives. They experience childhood as startups, they go through growth-spurts as smaller fast-growing companies, and if they survive the rigors of competition and the recklessness of youth, they become stable (if somewhat boring) pillars of society that advance their goals in a fairly predictable fashion.

Most of us have the benefit of having the awkward transitions between the phases of our lives occur mostly in private (unless we have the misfortune of being famous as children); but publicly-traded companies experience these awkward moments in the full glare of the spotlight. And just as everyone cringes when they hear a teenager's voice crack during the middle of a choir perforance; so everyone dumps the shares in a great company when it enters an awkward transitional period. And when the economy is slowing down, many companies go through awkward transitional periods.

Why They Get Dumped

Stock prices are based on expectations for future earnings, and when those expectations change, stock prices tend to move very quickly and to over-react to those changed expectations. When a company announces that it will grow earnings at only 20 percent over the next two years (or when analysts deduce and report as much), a company that has been growing earnings at 23% each year will drop a bit. However, a company that has been growing earnings at 30 percent per year which announces that it will only grow earnings at 20 percent per year will drop like a rock. The share price might go lower than it ever would have if the company had simply maintained a 20 percent growth rate the whole time.

There are quite a few reasons why the stock market over-reacts to dissapointments, but the most important one has to do with the very short timeframes on which most money managers have their performance evaluated. If your bonus and your job is riding on the performance of a portfolio over a 12-month span of time (as is true of mutual fund and hedge fund managers) then you don't care that a stock which just announced a slowdown in earnings is still a good value. You will sell so that you don't end up holding a stock that is in the dumps and blowing your annual bonus. Because professional money-managers dominate trading, and few are willing to buy a company trading at a value which might take years to appreciate in price, drops in earnings forecasts can put stocks on the chopping block.

And when money-managers smell a recession on the horizon, they dump consumer descretionary stocks (which is to say, stocks in companies that make things that people don't really need) indescriminately.

Two Great Companies to Buy Now

Starbucks (SBUX): Sure, the king of coffee is facing a consumer slowdown, rising milk prices which cut into margins, and competition from McDonalds. But, according to statements that Howard Schultz made in a recent interview in Fortune magazine, Starbucks sells less than 10% of the coffee consumed in the US, and less than 1% of the coffee consumed outside of the US. This leaves a lot of room for growth, undercutting analyst argumens that the market for this company's products is saturated. Now Schultz, the CEO who drove the company for most of its formative years, has resumed the helm of the coffee giant to address the recent drop in Starbucks shares. These shares are at multi-year lows, presenting a great opportunity for patient investors to buy a great business at a great price.

Coach (COH): This maker of high-end handbags is the poster child for unnecessary spending - after all, a $500 handbag makes a $5 latte look like a bargain. But, despite the slowdown in consumer spending, Coach's latest earnings report showed earnings growing over the last year by 16%, beating analyst estimates yet again. And the shares were recently selling at a price to earnings ratio of only 16 - the cheapest price since this company went public. On a recent visit to Bellevue Square mall, I noticed that the Coach store was packed. This is a great company, selling at an unusually low price.