Investing is hard, there’s no two ways about it.

If it were easy then a lot more Kiwis would be very rich.

This is likely no surprise to you.

The hard part about investing isn’t the accumulation of knowledge. Thousands of fund managers are incredibly bright and have decades of experience. Yet they still do worse than the index.

The hard part is reprogramming your natural instincts.

One example is what happens when investors hold a losing position. Its hurts.

Humans focus on the negative. We’re always looking for possible dangers and trying to avoid them, whether it’s a lion on the savanna or a declining tech stock on the NASDAQ.

It’s why you might feel uncomfortable holding a losing position. Nature is telling you to get out and that your original investment thesis was wrong — whether that’s true or not.

It’s why I believe, to be a complete investor you need to build up mental models over time. Ideas that transverse multiple disciplines to help you evaluate businesses, avoid potential problems and thwart your own biases.

One such model that’s rather simple comes from an economist by the name of Herbert Stein. Stein once said, ‘If something cannot go on forever, it will stop.’

It’s such an obvious idea that many of us tend to forget it.

And today I want to show you how Stein’s law will cause stocks (generally) to fall even lower from today’s levels.

 

This cannot go on forever: cheap money

In yesterday’s Money Morning, I mentioned stocks like Amazon.com, Inc. [NASDAQ:AMZN] and Netflix, Inc. [NASDAQ:NFLX].

Both stocks trade at very high levels, on absolute and relative terms. For you to buy either today and make a whole lot of money over time (I’m talking five- to 10-times your money), these companies need to pump out more growth than ever before.

Of course, the run both Netflix and Amazon are on cannot last forever. Sooner or later, investors will stop paying 60- to 100-times earnings for these stocks. And when that happens, it could be disastrous for investors that bought in at today’s prices.

We can also apply Stein’s law to the wider economy. Central bankers all over the world have kept interest rates low. Debt is close to free.

The more money that’s created, the more productive and unproductive projects that get funded. Businesses borrow money at 3% to acquire assets that generate 5% returns. Investors buy stocks with potential returns of 6% because bond yields are a little over 3%.

All these decisions are made as if interest rates will remain low forever.

But ask anyone and they will tell you cheap money cannot last forever. Businesses that borrowed at 3% to buy assets returning 5% start losing money when pay anything above 5% interest. At some point, investors stop paying good money for expensive stocks. They’re less enthusiastic and prices start getting more sensible. [openx slug=inpost]

This era of cheap money will end…at some point. And million dollar fund manager, Mark Holowesko believes it could cause the largest unwinding of risk in his entire career. The Australian Financial Review writes:

‘While global markets are readying for what Holowesko describes as the “biggest unwinding of risk that I’ve ever seen in my lifetime”, stock valuations in the United States have, until recent weeks at least, remained historically high.

‘And yet when he looks outside the US, the picture is very different.

‘“I can put together a portfolio of securities that are as cheap today as at any time in my career.”

‘Two great periods of tumult have shaped Holowesko’s career. First was the Asian financial crisis in 1997, which he says “almost destroyed my career” when he started buying Asian stocks at the bottom of the cycle and then “eventually solidified it” in 1999 when his portfolio climbed 40 per cent.

‘The second was the tech crash of 2000, which saw Holowesko make the decision to leave Franklin Templeton and set up his own firm, Holowesko Partners.

‘“There was such an extreme in growth versus value. That period was fraught with opportunity and risk,” he says of the dotcom bubble.

‘“This is at least as dramatic, or maybe more, than those two periods.”’

What really worries Holowesko is the level of corporate debt in the US. The Australian Financial Review continues:

‘Back in 2007, debt was around 162 per cent of US gross domestic product, but a decade on, this has ballooned to 324 per cent of GDP – an increase in dollar terms of $US172 billion.

‘Low interest rates have, of course, fuelled this debt build-up. But as rates start to rise again, the chances of companies being caught are huge.

‘Holowesko says that even at today’s low corporate borrowing rates of around 3 per cent, about 14 per cent of the companies in the S&P 500 cannot cover their interest costs with earnings before interest and tax, “which is crazy in this environment”.’

But take a look outside the US (and the NZX), and there are stocks trading for rock bottom prices with little to no debt.

 

Would you buy these two stocks?

One example is Samsung Electronics Co. Ltd [KRX:005930]. The Korean smartphone maker has traded down for the year, along with most other stocks globally.

At time of writing, you can pick up the stock for a little over six-times earnings. More than 25% of Samsung’s total assets are cash. Their net debt position (total debt less cash) is negative US$12 billion.

This is another situation where Stein’s law applies.

Can Samsung, a company that beats Apple, Inc. [NASDAQ:AAPL] in global market share for smartphones, continue to trade at a little over six-times earnings forever?

If the answer is no, then it’s extremely likely that Samsung’s low valuation will stop…at some point.

Swire Pacific Ltd [HKG:0019] is another example of a cheap company with very little debt.

The property, aviation, marine and beverage conglomerate trades for just 4.5-times earnings and less than one-time book value (assets less liabilities).

There are only a few of these mouth-watering opportunities in the US or here in New Zealand, with markets at such elevated levels. But with central bankers sucking money out of the system, bond yields rising and investors reassessing their future returns, it might not be long before you see billion-dollar companies trading for a pittance.

Get ready,

Harje Ronngard