Week #44 Buffett’s 2x per Century Bet; Small Caps Set to Double?; "The Most Wonderful Time of the Year."

Ackman Drops His Shorts; Investment Trends of the Decades

Today at a Glance:

One Quote: "Like having God just opening a chest and pouring money into it."

One Opportunity: Small caps set to double?

One Bullish Take: Profit from the “Power Period”

One Point Scored: Ackman Drops His Shorts

One Investment Trend: Past, Present, and Predicted

• One Quote

"If you're as smart as Warren Buffett, maybe two, three times a century, you get an idea like that…”

                                                                                                -Charlie Munger

Few in the investing world understood how Warren Buffett's bet on Japan was a once-in-a-lifetime chance to make a boatload of money with virtually zero risk.

Like many others, I thought Buffett’s investment was a verdict on Japan's coming economic renaissance.

I was wrong.

In a recent interview. Charlie Munger revealed the truth behind Buffett’s thinking.

In the summer of 2020, Buffett disclosed stakes worth $6 billion in five Japanese trading houses.

The bets caught Buffett watchers off guard.

After all, Berkshire famously favors American companies like Apple and Coca-Cola.

But as Munger, Buffett's right-hand man and Berkshire's vice-chairman, pointed out, Buffett's bet on Japan was more a clever arbitrage play on interest rates and dividends. The fact that they soared after Buffett’s bet was revealed was just a bonus.

With interest rates near zero in Japan, Berkshire borrowed cheaply in yen.

Buffett then used the funds to scoop up shares of old-guard Japanese trading houses offering juicy 5% dividend yields.

The carry trade was a bonanza on multiple fronts.

Berkshire's pristine credit rating let it borrow much more cheaply than rivals.

The trading houses boasted an array of assets - from copper mines to rubber plantations - throwing off steady cash flows.

 As Munger colorfully put it, it was

Shrewdly, Buffett amassed his position slowly through many small purchases.

Berkshire boosted its holdings from 5% to 7.4% over nearly two years. Buffett recognized that patience was vital to securing bargain prices without tipping his hand.

By locking in rock-bottom rates in Japan, Berkshire ensured almost risk-free returns.

The trade was Classic Buffett. He seized a rare moment when extraordinary rewards come with minimal risk.

The lesson?

Such opportunities arise infrequently. Patience and insight remain paramount. You must pounce decisively when conditions align so perfectly.

One Opportunity

Small Caps Set to Double?

U.S. small-cap stocks are in the dumps.

Investors ignore them.

Brokers take no notice of them.

The trillion-dollar market cap “Magnificent Seven” tech stocks make small caps seem like relics of the past.

All this conventional thinking should have savvy, contrarian investors licking their chops.

Here are three compelling reasons why.

First, small-cap valuations have plunged. The Russell 2000 index trades at price-to-book ratios not seen since the 1990s tech bubble. That’s a massive 30% discount to large caps. At one point recently, Apple’s market cap exceeded the collective value of all the 1,909 stocks in the Russell 2000 index. 

When you can cite extreme statistics like this, it's often the best time to buy.

Second, stock picking among small caps unlocks immense potential. Lower liquidity and scant analyst coverage make the small-cap market inefficient.

On some earnings calls, I am one of three analysts following the company. I gain rare insight into quality firms that few others do. The collapse in valuation is just a bonus.

Finally, the headlines scream recession. Yet some sectors are enjoying an economic boom. Robust consumer spending, strong employment, and healthy corporate balance sheets say soft landing, not “batten down the hatchets."

Once sentiment turns, small caps could easily double- as they did in the 12 months between March 2020 and 2021.

Small-cap industrials have outperformed tech stocks this year. Yet I bet this is the first place you're hearing this. As Mr. Market recovers from this current bout of depression, beaten-down small caps will surge.

In short, ultra-low valuations, inefficiencies demanding active management, and cautiously optimistic economic indicators underscore small caps' compelling risk-reward ratio. The time is ripe to seize the upside.

And that is precisely what I’m doing in my new Microcap Moonshot Millionaire investment service, launching soon. In the meantime, you can download my Special Report “The 10 Commandments of Microcap Moonshot Investing” to get you started.

One Bullish Take

“Power Period”: The Most Wonderful Time of the Year.

Data mining can be fun.

Sometimes, it can be even profitable.

Take Sentimentrader.com’s “Power Period”- the six trading days between October 27^th and November 3^rd.

These six days – we have just completed the second -have a strong history of bucking any gloomy market narrative.

The historical data are compelling.

First, in over 70 years of market history, this six-day period has seen the S&P 500 gain ground nearly 75% of the time. The frequency of positive returns handily outpaces the negative.

Second, not only have gains occurred more often, but gains have substantially outweighed losses. The average gain over 2% topped 6% (!), while average declines were limited to around -4%. Gains far outweigh the losses.

Finally, outsized gains of 3% or greater outnumbered similar losses by a stunning 14-2 margin over seven decades.

The long-term track record of solidly positive skewed returns is impressive.

And sure enough, as on cue, yesterday saw the biggest gain in the market since August.

But it could just be a statistical quirk.

If you do bet on a rebound, don’t bet the farm. And manage your risk and position size.

One Point

Ackman Drops His Shorts

Ackman is a remarkably cocky guy, even by the elevated standards of Harvard Business School grads.

Ackman once played a doubles charity tennis match against tennis legend John McEnroe.

Ackman, a tennis player at Harvard, violated the unstated rules of charity matches by amping up his game to defeat McEnroe, a former Stanford NCAA champion.

McEnroe also turned up his game. Predictably, the three-time Wimbledon champion went on to crush Ackman.

But Ackman has once again proven his market savvy, pocketing $200 million on a well-timed short bet against 30-year U.S. Treasuries.

Three factors converged to make his trade pay off handsomely.

First, Ackman initiated his bearish bond position in August when long-term yields sat around 4.3%. He argued that persistent inflation would force the Fed to keep hiking interest rates. This prescience turned out to be correct.

Second, he structured the trade using options to limit his downside risk while benefiting from the upward trajectory in yields. The optionality paid off as 30-year yields spiked to over 5% at their peak.

Finally, Ackman timed his exit impeccably, closing out the profitable trade just as geopolitical tensions sent yields falling. While the $200 million gain is small compared to previous homerun trades, it boosted his Pershing Square fund by 11.6% this year.

In summary, Ackman's bond bear play combined shrewd market analysis, savvy risk management via options, and expert timing on the exit.

It also means that Ackman believes that interest rates have peaked.

Investment Trends

Past, Present, and Predicted

I am a big fan of financial history. (I publish weekly excerpts of my upcoming book on The History of Financial Manias on “The Bubble Blog”).

This graphic from Morgan Stanley Investment Management highlights critical investment themes over the past 70 years.

Each decade tends to be characterized by outsized returns in one particular asset class or region.

These investment themes are driven by a narrative of some sort- whether macroeconomic factors, geopolitics, monetary policy, or structural shifts like technological innovation.

In the 1950s, European stocks saw significant gains as post-war rebuilding fueled investment in the region.

The 1960s saw flows into the "Nifty Fifty" group of stable American large caps like Johnson & Johnson, Coca-Cola, and Disney.

The 1970s were driven by rising oil prices, a commodities boom, and emerging market exporters. Gold also rallied during this period.

The 1980s were the decade of Japanese stocks. The top performers of the decade, they briefly overtook U.S. stocks to represent 41% of global market capitalization by 1989.

U.S. technology stocks drove the 1990s, although many dot-com high-flyers later crashed. Amazon and Google emerged as long-term winners.

The 2000s brought back emerging markets and commodities as top performers, especially BRIC countries and oil exporters.

Lastly, U.S. mega-cap tech stocks like Facebook, Apple, Amazon, Netflix, and Google delivered outsized returns in the 2010s.

What’s Next?

After dominance from American mega-cap tech stocks over the 2010s, Morgan Stanley expects global equities to take center stage.

Here’s why…

First, US equities account for 43% of the global stock market but only 26% of economic output. This market concentration is the highest in the last 100 years.

Second, since 2009, U.S. stocks have dramatically outperformed international peers by over 100 percentage points. Global equities are due for a decade of catch-up gains.

Third, a weaker dollar and commodity super-cycle would disproportionately benefit international companies.

What’s “the dog that didn’t bark” in this analysis?

Two years ago, China would have dominated the global narrative.

Now, it barely merits mention.