As with anything in economic forecasting, what I am about to say is at best an educated guess.  Given the present environment, where is the global economy likely to go?

Any analysis like this has to contend with political factors that drive the major imbalances of the global economy.  Here are the imbalances as I see them:

• China insists on keeping its currency cheap in order to promote employment at home.
• The US does not care about deficits or currency debasement, as it seeks Keynesian remedies to its economic crises.  (Little realizing that they are making things worse…)
• The Eurozone protects profligate euro-fringe nations, at the possible cost of destroying the Eurozone as a whole.

If China will not allow its currency to strengthen, well then, the path of least resistance is for the US to debase its currency, leading the world in a cycle of competitive debasement/inflation.  Since many nations want to be net exporters, US Dollar weakness is responded to through debasement, or purchase of US Dollar assets.

Putting it simply, the path of least resistance is inflation.  Reduce the value of nominal debts in real terms.  Eliminate underwater debts by raising the nominal prices of the collateral.

Now, surplus nations like China and Germany will resist this, but I suspect they will be dragged to this, kicking and screaming.

We are in the process of trying the alternative approach to solving the Great Depression via inflation, which will have a different set of problems than the foolishness of FDR.  The problem is too much debt, which needs to be changed into equity, but government tinkering discourages compromises.

Rather than the deflation that characterized the Great Depression, inflation may be what drives the future.  The question could be “how much?”

But all that said, there are other possibilities.  We could raise taxes and pay off the debt.  We could default on the debt.  Neither of these are favored by current politics, but they could happen.

So as you invest, consider an inflationary bias.  I think it is the likely wave of the future.

Here are the eight rules with links to my recent pieces:

1. Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.
2. Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.
3. Stick with higher quality companies for a given industry.
4. Purchase companies appropriately sized to serve their market niches.
5. Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.
6. Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.
7. Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
8. Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

For the most part these are rules that would only serve a value investor.  They focus on the first principle of value investing, which is “margin of safety (rule 3),” and after that on the less important principle of buying them cheap (rule 2).

I would add the concept “sell them relatively dear,” which  rules 7 and 8 spell out.  The sell discipline gets short shrift in much of value investing, and I think I have a very good sell discipline.

But value traps do in many value investors.  Value traps are companies that are cheap, but cheap for a reason.  How do you avoid value traps?

• Try to have industry factors working for you (Rule 1)
• Look for companies that still have some room to grow (Rule 4)
• Avoid companies that are aggressive in their reporting of income (Rule 5)
• Look for managements that use their free cash flow wisely (Rule 6)

I have my failures, but I don’t trip into many value traps, relative to the average value investor.

That is how my rules work together.  They are meant to cover the basic areas of value investing, while attempting to avoid the traps that harm value investing.

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This is the end of the “Portfolio Rules” series.  From these articles, I hope you get a good idea of how I invest, whether you invest like me, or invest with me.