Lessons From Another Market Rotation

 | Mar 31, 2014 | 4:22 PM EDT
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"Heinz ketchup will never be replaced by the Chinese." Yep, that's what I told my clients at Goldman Sachs when they wanted to know what stocks I liked. "And Kleenex will always be a household name."

Heinz and Kimberly-Clark, my two favorite stocks to recommend to clients in my four years at Goldman Sachs, were naturals to be the first stocks I bought for my hedge fund when I started 27 years ago. Why not? They had all of the unassailable characteristics of what you want from stocks: best of breed, reasonably but not outrageously overpriced, excellent seasoned management and products that couldn't be supplanted by cheap overseas imports -- unlike just about everything else in those days.

They were core positions, and when I went out to meet with prospective clients to tell them that these were my core positions, almost every single one I met was thrilled that I was thinking in such long-term, well-stated principles. They were my two largest holdings, among many others that looked like them, and I felt confident in these kinds of picks to get my business going.

I was confident, so confident that I never thought a clause that I had accepted in my agreement, to open up my fund and give the money back if my performance fell 10%, could ever come back to haunt me. These kinds of stocks, I reasoned, just don't have those kinds of falls. They are slow and steady with minimal volatility and a nice upward trajectory over time, classic secular growth stocks that sometimes took breathers but otherwise just created wealth, regardless of the season.

That is, until that particular season. Just a few weeks into my hedge fund stewardship, the economy, which had been bouncing along constructively, suddenly hit a level of acceleration the likes of which any policymaker in this era would kill for. It was if someone flicked a switch, and everything from homes to cars to retail sales just notched up in a way that took people by surprise.

You could tell because the indicators I followed, the price of containerboard, the cost of the basic plastic building blocks such as ethylene and the amount charged for gypsum board all seemed to jump at once. Industrial production had several months of increases, and you began to hear of shortages developing for very basic products that had been pretty slack for ages.

I knew what you had to buy if you wanted to win in that environment: Stone Container, which was then the biggest containerboard company, Dow Chemical and Monsanto -- the latter hadn't become a biotech yet -- and Bethlehem Steel, the steel company most levered to the hottest areas of construction.

I knew what you had to sell, too: Heinz and Kimberly-Clark. But I had told my partners that that wasn't how I was going to play it. I was in it for the long run. I wasn't going to abandon my core positions just because of a momentary increase in economic activity. Besides, there was nothing "wrong" with these two companies. Sure, maybe the raw cost of the glass for Heinz might head up, or the cost of packing tomatoes. Maybe Kimberly could be hurt by rising pulp prices, but they were so well hedged. I was just going to let things be and ride it out.

But this surge of business didn't abate, and the money came pouring out of the consumer staples, as you call these kinds of positions I liked, to fund buys in Champion Paper, Georgia Pacific, Georgia Gulf, Visteon and so many of the other commodity-related entities of the era that are too numerous to count.

You would come in every day and listen to the brokers discuss the merchandise they had to buy and to sell, and it was always the same. "Better buyer of the papers, the chemicals, the hard goods, the steels, the aluminums, the coppers; better seller of the soft goods, the soaps, the foods." It got to be to the point that I figured I could just go buy Reynolds Metals, Phelps Dodge and Alcoa and forget about everything else, to name the three most down and dirty commodity plays that were in vogue in those days.

Yep, I was sticking to my guns. Until there was a week when every day the money poured out of the staples into the economically sensitive stocks, and each day that week I saw my cherished Kimberly and Heinz drop precipitously. By Thursday of that week, my fund was down almost 8%, largely because of the rotation.

I furiously threw my excess cash at DuPont and U.S. Gypsum, at U.S. Steel and Alcan and Inco. But it just didn't matter. I couldn't make up for the losses that Heinz and Kimberly and others I owned, such as the sainted ones, Coca-Cola and Merck, were generating.

I came in that following week, and I was down 9%. If I were to tick down one more percent, then I would have to open my fund, and everything I had worked for and prepared for years would disappear. It would be the single most abject failure of my life. I would be blown out, three months into my dream.

But the alternative was to go back on every single principle I had promised to my investors: to think long term, to take core positions and stay close to them and to own only the best of breed.

I decided I had no choice. I walked in the next day, and I sold everything, every single stock I owned. Went totally into cash. Chucked the Heinz like it was a used-up bottle of ketchup, ditched the Kimberly like a snot-filled Kleenex.

I remember getting the "run" the next day, which is what you call the daily brokerage report that Goldman gave to me, and it showed that I was down 9.5% and in all cash. I didn't have to open, and that meant I wouldn't be closed by withdrawing partners.

And with that, I bought all the containerboard, basic chemical, steel and aluminum plays that I could and got back to even in no time. The rest is pretty much history well documented, audited, whatever it takes to get even the haters to accept the amount of money I made.

Now, a whole new group of investors is faced with a similar rotation like the one I just described. The companies that are going down this time are cloud-based or biotech based, but they might as well be Kimberly and Heinz and the other 1987 killers, except that they are a little more volatile, to say the least. Plenty of people want me to "defend' them or want to know why I don't "stick up for them" or "promote them" or "tout" them or whatever other words people use to try to goad me into doing something.

And to be sure, just like with Heinz and Kimberly, I don't think there is anything "wrong" per se with the more solid of the cloud or biotech companies. But I can tell you that throughout the hedge fund world there are managers like I was back in 1987 who, one by one, are saying, "I can't take it anymore." And they are throwing out Gilead (GILD) and Salesforce.com (CRM) before their money is taken away. I lived through it. I know it will run its course. but until it does, I know better because of what happened to me back then.

Individuals can own stocks through hell and high water. Institutions can't. But if you don't know what you own or why you own it, you will, in the end, be broken by this kind of selling. So respect the rotation, because it is always bigger than you and your stocks are. Recognize that there may be nothing more wrong with these biotechs and cloud plays, any more than there was with Heinz and Kimberly back then. If you have to, do some selling to save your sanity. But recognize that it's just the mechanics of money management at work, as portfolio managers jettison the great growers to buy the down and dirty industrials to try to keep their jobs and stay ahead of the game. 

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