Posted by David Tillson 2008 Third Quarter
I have started writing this letter several times during the past two weeks and each time, I have had to start over after some late breaking news changed the tone of what I had already written. We are living in times where circumstances are certainly unprecedented. The financial markets have experienced bear markets in the past, some of which have been quite severe and created a sense of despair and panic. However, it seems that this one is very different because we have seen so many major financial institutions sink into bankruptcy or forced sale. Financial conditions around the world are clearly in a critical state and although extremely remote, one can not dismiss the possibility that the world will experience a complete financial meltdown. What has been surprising is the speed and severity of the seizing up of the credit markets and the panic that has engulfed markets around the world. The US economy is still the strongest and most resilient in the world, but it is clearly reeling from all of the problems that have been endlessly discussed in the news during the past several months. The party that was fueled by almost endless borrowing of cheap money is now over. Risk was only a word that was mentioned for legal reasons or to suggest that an investor could make a higher return if they took on more of it. Like that party that went on into the wee hours of the morning, we have now woken up with a tremendous hangover that mere aspirin will not touch. Just as rest, time, and some healthy living cure a hangover, the deleveraging process requires some of the same tonic. There is no quick fix and some pain will continue to be felt by all the attendees at the party and even by some who were only neighbors. All countries around the world are being impacted by the shedding of debt, and those investors who thought that the emerging markets had become de-linked from the US and Europe have realized otherwise. The world is still very much connected and the solution to the current state of affairs will be a coordinated global one. I believe that everything in life is cyclical and that this cycle will eventually turn, but the timing is uncertain and some more pain is likely. That being said, stocks usually do a fairly good job of forecasting and with the US market down about 42% since the peak just a year ago, they are already discounting a substantial decline in the fortunes of corporate America. I don’t intend to write a synopsis of the events of the past few months, but I would like to comment on our view of what is happening and give a historical perspective as we interpret it.
Putting the current conditions into the context of 9 decades can give a very different picture than when one considers only a few months. For more than the 90 years shown below, the market has been buffeted by fear and greed. History does not repeat exactly, but the forces that have driven the markets really have not changed that much over time. Prices are set based on what investors know and on what they think they know, or at least what they hope for and what they fear. Stock prices have risen over time at a 6.5-7.0% rate on average and dividends have added another 3.5-4.0% to investors’ total return. But clearly, this 10% average return does not occur each year. In fact, using month-end prices, 12-month returns in the post war period have ranged from a high of 61% to a low of -39%. Thus, this intramonth decline of -42% would set a new record if prices stay at the low for the remainder of October. This chart shows clearly two of the three stock market bubbles since 1925.
The Nifty-Fifty bubble of the 1968-72 period does not show up on this chart because the lower P/E stocks such as AT&T, GM and US Steel still made up a very large part of the index and overshadowed the high P/E Nifty-Fifty stocks such as Xerox, Polaroid, Coca Cola, IBM, and Avon.
Each of these periods of “greed” was followed by approximately 12-15 years of a languishing market while investors reset their beliefs about risk and return. These periods where investors’ belief systems are being reset actually create tremendous opportunities for long term fundamental investors. Whereas momentum and “buy-the-story” investing worked leading up to these periods, true stock picking and investing for the long term works in these times of uncertainty and higher volatility. We appear to be about 10 years into the tech bubble reset and if history can be used as a guide, we have probably seen most of the worst of it, especially when we see many investors now wanting to sell their holdings at any price. When the market does reach bottom, it is only known in hindsight; no bell announcing it is ever rung. And, since the news will continue to be negative for many months after the bottom, most investors will not get back in until they are comfortable - usually 1-3 years later. The long term fundamental investor who remained invested, while having been left in a very lonely position, finally reaps the reward of being surprised on the upside and is well ahead of the general investing public who has waited to be comfortable before buying. Successful investing is not about comfort; it is about seeking out risk and once found, understanding it and managing it.
Today we are dealing with conditions and forces that we have not had to deal with in many decades. In some respects, the current environment is a little like that in the 1925-1935 period when excessive leverage (the ability to buy stocks with 90% margin debt) led to the Roaring 20’s stock market bubble that eventually collapsed in 1929. The deleveraging process then was quick and brutal as margin calls led to a massive liquidation of stocks, and became a vicious cycle as it unwound. It was not unlike real estate investors of the past several years using easy-to-get debt to buy properties with the intent of flipping them before their debt needed to be serviced. In the 1930’s the situation was exacerbated by the lack of a strong positive central government response, in large part because the institutions and regulatory authorities that we have today were not created until the mid-1930’s after the damage had already been done. One major and critical difference is today’s central governments are putting massive amounts of liquidity into the system in stark contrast to the 1930’s tightening of the money supply which made a bad situation much worse. We do not intend to at all suggest that we are faced with a 1930’s environment; rather, we wish to point out that even under those dire conditions, economies and markets recover. Fear and even panic are not only conditions to be expected at various times in the market’s continuum, they are necessary to wash out the over-confidence and under-estimation of risk. The problem for investors is that it is difficult, if not impossible, to tell with any certitude the timing and magnitude of bull and bear markets. The chart below illustrates the depth of bear markets that have occurred since WWII.
The declines are measured using month end prices, so the peak-to-trough declines are actually about 5% greater than shown. We have experienced two major bear markets where the S&P 500 Index declined 48% peak-to-trough. The current decline is 43%, with half of that occurring in the last 10 days. Despite the fact that we are now either entering or already in a recession, stock prices have most likely discounted a worst case scenario, barring a major meltdown in world economies. The major bear market in 1973-74 was preceded by worsening bear markets, caused in part by the normal business cycle, but exacerbated by rising interest rates through the 1950’s and 1960’s. The 2000-02 bear market was preceded by a decade with no bear markets. The doctrine of greed was well entrenched and too few investors had experienced loss to such an extent that they were fearful. The mantra was “buy on the dips” and momentum investing worked far too well to be ignored. The 2000-02 bear market caused investors to again have a healthy respect for the stock market, but not necessarily for risk. Low short term interest rates in the early part of this decade made the carry trade (borrow short term to invest longer term) very profitable for financial institutions and hedge funds. As interest rates remained low, investors had to be more creative to generate high returns. Borrowing larger and larger amounts at low short term rates to invest long allowed a 3% return on equity to turn into 30% if a fund borrowed 10x the amount of equity. Once this excessive risk taking behavior goes to an extreme, conditions become ripe for a sharp correction. In our present circumstances, while a few people did warn of the excesses and the leverage, even fewer had the insight as to exactly how much leverage and risk was really in the system. While there is a great deal of uncertainty remaining, one thing is very certain: just like the mid to late 1930’s, we will see a very significant increase in regulation and oversight going forward.
Three months ago few imagined that the likes of Fannie Mae, Freddie Mac, Lehman, and Wachovia would no longer be public companies, that AIG would only barely be so, and that GE and AT&T would not be able to roll over their commercial paper. Our portfolios at Eagle Ridge have been structured since summer so that we had a balance of defensive and offensive positions. The markets had been weak, problems in the housing area were evident, and we were of the belief that the US probably had not yet entered a recession, although one was possible. International markets, while strong, were not immune to problems in the US and we believed that energy prices would probably decline from the lofty levels of the 2nd quarter. What we failed to anticipate was the panic created by the seizing up of the credit markets that has overtaken more rational investing. Fundamentals no longer matter because no one really knows how bad the future will be – only that it will be much worse than anyone expected earlier this year. Our portfolio’s performance is ahead of the S&P 500 Index by approximately 600 basis points through September 30th which is still small consolation when the market is down 19.3%. Financials were underweight the index and the positions held were, after a devastating prior six months, what we felt would be the survivors. In fact, four of the top five contributors to performance for the quarter were bank stocks, including JP Morgan, US Bancorp, Bank of America and Citigroup. Procter & Gamble was the fifth top contributor. The detractors included AIG and AT&T, along with three energy related companies – Halliburton, Questar and PPL Corp. We normally comment on stock performance in more detail, but this past quarter’s and the first two weeks of October’s performance is being driven largely by non-fundamental factors.
In summary, conditions today in the financial markets are frightening and bordering at times on panic. Volatility is probably higher than any time since the 1929 period and the inability or unwillingness of banks to lend is the worst that I can remember in my 35 years in the business. However, it is times such as this that experience, process, good judgment, and a historical perspective are very important. History can not tell us what will happen in the future, but it can tell us how people have reacted to events in the past. In a very general sense, the stock market is nothing more than owners of companies having a place to buy or sell that ownership. The volatility that we experience is the emotional part of that buy / sell decision. The fundamentals of the companies do not change based on who is buying and selling, but they can change if the economy or access to capital changes. Today, we see many, many companies which are financially sound and have a very positive future, and are selling at valuations that are more compelling than we have seen for many years. Given the state of affairs around the world, it is unlikely that inflation is going to be a problem in the foreseeable future, which means that the valuation of the market should rise from its current 13x level to the 15-17x range. The risk therefore, is earnings, which in the near term should decline further as we enter a recession. Earnings of the S&P 500 Index did decline very sharply in 2001-2002 reflecting write-offs and collapsing companies.
Today’s decline reflects some of the same forces, but looking at the 90 year trend, it appears highly unlikely that earnings will not return close to the trend line sometime during the next few years. Should this happen, or actually, when this happens, then this period will be viewed as one of the best times to buy stocks that we have had for some time.