2010 Second Quarter

Posted by David Tillson 2010 Second Quarter

As we enter the second half of 2010, investors are still faced with an unusual amount of uncertainty, a reduced appetite for risk, and a barrage of mostly bad news from the media. The sharp recovery in equity prices leading up to the second quarter was brought to a halt in May and June as the market declined 15% from its April peak. Stocks were weighed down by the Euro-area sovereign crisis, a loss of confidence in the global economic recovery, and the Gulf oil spill. Many investors and corporations are waiting for more clarification of future direction before committing funds to long term investments. The past decade has already been the worst for equity investors since the 1930’s, and many are still worried that the next will not be any better.

Since the March 2009 lows, investors have shown a clear preference for bonds over equities. Both bond and equity risk premiums declined fairly sharply during the March to September 2009 rally, but from October onward, bond spreads continued to decline while equity risk premiums reversed their path and started rising once more. This suggests that despite uncertain economic outlooks, investors are comfortable reaching for yield in credit but equity investors are not. Year-to-date in 2010, investment grade corporate bond funds have seen inflows of $23 billion while US equity funds have seen outflows of $24 billion. Deflation, which is one of our worries, would make investors favor bonds over equities. However, we believe that while tremendous uncertainty about the future remains, large, high quality, “blue chip” companies will produce among the highest returns of all major asset classes during the next decade. 

Benjamin Graham, who taught at Columbia University starting in 1926 and wrote on investments for thirty years, is regarded as the father of modern day security analysis. Warren Buffet, one of his students, describes Graham’s book The Intelligent Investor as the best book on investing ever written. Jason Zweig, a financial journalist, recently found a 1963 lecture by Benjamin Graham titled Securities in an Insecure World which contains many nuggets of wisdom given today’s insecurities.  In it, Graham discussed some basic guiding principles for financial security as it relates to stocks and bonds. I focus on three of his principles as being particularly relevant in today’s chaotic times. Principle one is that market fluctuations cannot be avoided and that investors should understand their own ability to live with volatility. While we have recently experienced some catastrophic declines in certain stocks, Graham reminds us that investors have seen these declines before. In 1962, IBM declined from $607 to $300 in 6 months, GE from $100 in 1960 to $54 in 1962, and US Steel from $109 in 1959 to $38 in 1962. These were well established, strong companies that had become substantially overvalued, and they suffered much worse than average declines when the overall market fell. Principle two is that price does matter. Graham is skeptical of the value of longer term business forecasts. He is similarly skeptical of finding much value where there is general agreement of good future prospects because that future is likely to be fully reflected in the price. However, the contrary case of “Nobody likes this stock, nobody has confidence in it, but I have confidence in it and I know its results are going to be better in the future” can have value. Principle three is that Graham believes that it is possible for a minority of investors to get significantly better results than average. The two necessary conditions are that they must follow sound principles of selection and their method of operation must be basically different than that of the majority of security buyers. One final passage from his lecture struck me as particularly relevant. He was presented with questions by a savings-and-loan company representative after the May 1962 market break: “The first question he asked me was “Don’t you think that common stocks now are less safe than before because of the decline in the market?” That hit me between the eyes. Here were financial people who could seriously consider that stocks less safe because they have declined in price than they were after they had advanced in price.” Ben Graham was one of the first to study investors’ behavior as it relates to valuing stocks. As uncomfortable as it can be, buying stocks that are depressed can be far more rewarding than buying those that have already provided investors with high returns.

The two charts shown below illustrate the lack of predictability of stocks in the short-term versus the relative stability of annualized price changes when measured over 10 years. It is quite evident that volatility of returns is simply part of the fabric of investing, but as can be seen in the chart on the right, returns have been much more predictable over a longer term. More importantly, long periods of high returns have been followed by periods of low returns, and now is clearly not a high return period! But, as Graham asked, how can financial people believe that stocks are less safe because they have declined in price. I suspect that many would respond to Graham that conditions have changed and that the future is more uncertain than when prices were higher. While that is true, it is also true that the basis of the problems that we face today have been with us for many years, but too few people were then as focused on these problems with the clarity that they have today. 

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We are certainly not unaware of today’s difficulties. Stubbornly high unemployment, soaring debt, increasing taxes and regulations, massive deficits well into the future, and huge unfunded liabilities in state and local government pensions and health care plans are all seemingly unsolvable. Given this, the glass can certainly be viewed as half empty with little time remaining before it is drained. On the other hand, one of the silver linings is that out-of-control spending, unfunded mandates, and many other previously untouchable issues are now being seriously discussed. The upcoming elections will be telling as to whether government spending can ever be controlled. Businesses today have accumulated huge amounts of cash on their already strong balance sheets but they need some clarity about the future of tax and regulatory policies before committing this cash to capital projects or serious hiring. 

Our view of the near future is as follows. The US consumer has seen substantial balance sheet repair and corporations are healthier than any time since the 1950’s. Employment will ultimately be the key to economic growth and Washington must do more than jawbone to convince the private sector to hire. Despite the disincentives that are sometimes created, unemployment benefits will be extended because hiring is still weak. The deficit will begin to be addressed – not through ever increasing taxes, but with spending cuts and reductions in entitlements. Inflation will remain low and we may experience some deflation, but we do not believe that deflation will become entrenched. Housing will eventually stabilize if it has not already, but material increases in housing prices are a long way off. The expiration of the Bush tax cuts may be delayed because the economy is still too fragile to accept such a massive tax increase. Finally, a material shift in Congress in November will result in a major rally in the stock market. In summary, our outlook is positive, but challenged. The safest haven, in our opinion, for protecting against both the loss of principal and the loss of purchasing power, is to invest in financially strong, large, high quality companies who have the capacity to change as conditions warrant and to reward their owners with increasing dividends. The value that the market may place on these companies will fluctuate, but eventually, their underlying value will be recognized.

In his lecture, Ben Graham touched upon those conditions that he believed could produce better than average returns over the long run. The investment process at Eagle Ridge is based on those beliefs: our method of stock selection begins with sound investment analysis; our portfolio management discipline is based on a reasonable sell target; our investment horizon is beyond that of most investors making normal volatility moot; and our contrarian bias and an understanding of investors’ behavior keeps us from following the herd. We believe that these are the qualities which will build wealth into the future.