2013 Third Quarter

Posted by David Tillson 2013 Third Quarter 

 “10,000 in 2010” was a catchy phrase referring to the Dow Jones index (DJIA) that we had used to help focus clients on long term investing. We first started using it during the tech bubble when many people became believers in “trees do grow to the sky.” It was created simply by extrapolating the long term growth in earnings out 10 years and multiplying by a P/E ratio of roughly 10x. Simple, yet effective and surprisingly quite accurate. Our new mantra is “25,000 in 2020.” Not quite as catchy, but likely to be just as accurate. The details will be discussed at the end of this letter. 

Ever since early 2009, the stock market has been climbing the proverbial “wall of worry” and by staying invested, a portfolio replicating the S&P 500 Index has now grown, with dividends, to a level 30% higher than it was at the end of 2007. During the particularly worrisome periods, long term investors who were true owners, found solace in their rising stream of dividend income even while the value of their portfolio was bouncing around like a soccer ball. As we have written before, volatility is certainly unsettling as one experiences it, and it is true risk for the short term trader. For a longer term investor however, it is simply noise. More important to the investor is the fundamental health of the companies in which they invest, and the health of the economic environment in which the companies operate. Companies are dynamic organisms which can usually adapt to their environment but they must remain competitive since their environment is ruled by survival of the fittest. 

The goal of many investment managers is to make assets grow at the highest reasonable rate possible while avoiding significant, permanent loss of capital. A consequence of the recent market strength is that the difference between current prices and our sell targets has been reduced, thus tempering the potential return that we expect in the next two to four years. Some say that we have, in effect, borrowed future appreciation as we profited from the stellar returns of the last 18 months. While this is technically correct, it does not mean that we must pay back these high returns; it simply means that future returns will not be as high as they could have been if the starting price were lower. This is not a terribly complicated concept, nor a surprise. The idea of borrowing and repayment however, does apply to our economy and to some extent to our analysis of companies. 

The Merriam-Webster definition of borrowing is “to take and use (something that belongs to someone else) for a period of time before returning it.” As we think about the recent government shutdown, it appears to us that the main reason for it is that spending is outpacing income which requires borrowing. Few people seriously believed that the US government would actually default on our existing debt, but there are many who believe that we will be unable to meet our obligations in the future unless the rate of increase in debt changes soon. In fact, the Congressional Budget Office states that Federal debt held by the public is now about 73% of GDP, higher than at any point in US history except for a brief period around WWII. They further state that under current laws, after a few years of stable debt-to-GDP ratios, the ratio will climb to 100% of GDP in 25 years, even without accounting for the harmful effects that growing debt would have on the economy. While this debt need not necessarily be paid back in full, it must be serviced. The US has built up this debt under historically low interest rates which makes it appear painless and non-problematic but this will change for the worse as interest rates rise. 

Taxes as a percent of GDP will very likely increase which means that it is future generations who must pay back today’s borrowing. A recent article from the Wall Street Journal “Stanley Druckenmiller: How Washington Really Redistributes Income” expresses an insightful, very well articulated explanation of how federal entitlements like Medicare and Social Security are letting Mr. Druckenmiller’s generation (boomers) rip off [sic] Generation X, Y and Z. To sum up the article, today’s 65-year-olds will receive on average net lifetime benefits of $327,000 while children born today will suffer net lifetime losses of $420,000 as they struggle to pay the bills of aging Americans. His theme of “generational theft” may (or may not!) seem harsh, but it is probably true. Because the level and trajectory of our debt is so important, we will continue to have bruising battles in Washington, at least until both parties are able to negotiate honestly. We will revisit brinksmanship but are not fearful of an actual default. 

While we don’t invest based on this type of macro analysis, we do believe that government’s policies and regulations are relevant factors to consider in our fundamental analysis of individual companies. For example, we have believed for some time that the fair value interest rate for the 10-year US Treasury Note is about 3.5%, a level that we were beginning to approach in early September when investors believed that the Fed’s bond buying program would be tapered. Portfolio holdings such as Schwab and State Street have already risen sharply on the expectation of higher rates and we expect that that their earnings will be able to expand materially from current levels as the economy grows and interest rates rise. Health Care is another area where macro factors are impacting company fundamentals. Our UnitedHealth Group holding is both a beneficiary and a potential victim of changes in our health care system necessitated by the Affordable Care Act (ACA). AbbVie and CR Bard should also benefit from higher demand for their products, but may fall under more regulatory control from the ACA. Balancing our fundamental company analysis against outside macro forces is what makes our life interesting. 

How did we get to “25,000 in 2020?” Earnings for the DJIA are estimated to be about $1,100 in 2014. Earnings for the market in general have grown at a 6.7% normalized rate for the last 85 years. If we extrapolate this growth rate, estimated earnings in 2021 would approximate $1,700. With the market’s P/E ratio remaining in the 14-15x range, the DJIA will reach 25,000, giving investors an annual return, including dividends, of at least 9%. While this is not an official prediction, we believe that it is certainly more than reasonable. The line from 15,000 to 25,000 will not be straight because earnings growth will ebb and flow and what investors are willing to pay for those earnings, the P/E ratio, will be even more volatile. Fear and greed affects P/E’s, not earnings. As we have discussed in past letters, ownership will be rewarded over the long term. For short term investors, John Maynard Keynes probably best summed up the challenge when he likened the investment process to predicting the outcome of a beauty contest. “The trick,” he said, “was not to pick the most attractive contestant. Rather, you have to assess which entrant the judges would find most comely.”  

To us the backdrop of the equity market still appears very attractive especially relative to other asset classes. By nature, we are optimists, but our optimism is grounded in realism. We do not believe that trees grow to the sky, nor do we believe that temporary short term losses are avoidable. We do believe that our economy will grow, that Washington will eventually do what is necessary to keep the US strong, and that companies will be able to compete and grow in the world market. This backdrop is the foundation for our investment process which focuses on companies’ fundamental earning power, dividend paying ability, and our longer term sell targets.