2011 First Quarter

Posted by David Tillson 2011 First Quarter

The one thing that can be said for the world today is that it’s not boring! Every week seems to bring another round of nerve jarring news. If mankind itself is not creating the news, then mother nature is. 2010’s stories of the BP well disaster, WikiLeaks’ War Logs disclosures, Haiti’s earthquake, the Chilean mine rescue, and the air travel mess from Iceland’s volcano are all but forgotten. We now are dealing with the Japan earthquake/tsunami/nuclear disaster, political unrest in Egypt, Bahrain, Libya and Syria, union protests in Wisconsin and other states, and the political theater regarding the Federal budget and debt ceiling. A decade ago, we can all probably remember certain personal events such as weddings and births, and a few major events such as September 11th and the tech bubble crash. But the details of most events seem to fade into our general memory bank leaving just emotions and reactions. These emotions and reactions, however, can be very strong and can shape our lives forever.

If we think ahead ten years, will we remember today’s events with the same clarity and concern? Probably not, but our behavior will certainly have been influenced by some of them. Consider how the collapse in the economy and especially in housing prices have changed peoples’ beliefs on investing, saving, and their ability to plan for the future. Today’s worries still include unemployment, rising commodity costs, continuing declines in home prices, a massive budget deficit, and unrest in the Middle East. Some of these worries will have a material impact on peoples’ lives while others will probably fade away. High unemployment will undoubtedly cause many people to save more than if they were still living in the 1990’s. If gas prices continue toward $5/gallon, energy conservation efforts will accelerate beyond what government fiat will do. And the budget battle in Washington will be a distant memory if Congress gets the deficit under control, but will remain very fresh if deficit spending remains uncontrolled for another few years. 

We have often talked about nearly everything in life being cyclical, about emotional human behavior, and about how reversion-to-the-mean can be so helpful in projecting the future. Identifying longer term trends is useful in investing, but only if the investor is patient and has a long term focus. Fads burn out, booms turn to busts, and irrational behavior eventually dissipates, but trends play out over long periods of time. Demographics is the study of population characteristics and is an area where trends will play out in the long term. One classic example of societal change being driven by a demographic change is captured by the baby boomer generation. Today, these 47 to 65 year olds are beginning to retire. As illustrated in the chart below, they are the last generation to have experienced interest rates rising on a secular basis, so anyone younger than 50 today really has no strong memory or emotions about how rising interest rates can impact them. Although they were only in their twenties, most boomers have vivid memories of inflation and rising rates because it hit them when they were just getting their adult life started. After rising sharply in the 1970’s, inflation actually declined rapidly in the early 1980’s, but real interest rates (after inflation) remained stubbornly high for many years. 

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During the 1980’s, the baby boomers were borrowing rather than saving. High real interest rates resulted in a transfer of wealth from borrowers to lenders/savers. Today we are living in an interest rate environment directly opposite from the 1970-80’s and it is now the lender/saver who is returning that wealth to the borrower. Conditions favoring either borrowers or savers usually exist without much impact on either group. A much more powerful impact on the boomers was the secular decline in interest rates over the past 30 years. In a declining rate environment, ever increasing leverage paid off for borrowers – for a while. Continuous refinancing of debt at lower cost, and ever rising debt loads to buy “can’t fail” investments, eventually led to disaster. Now, as the baby boomers are beginning to turn 65 and retire, the world as they knew it has been turned upside down and their views on investing with it. While this is a very simplistic explanation for what occurred over a 50 year time frame, it does illustrate that human behavior is driven by the strongest memories and that cycles can sometimes take decades to complete. The boomer’s children will likely not make the same choices as their parents, but if history is any guide, their grandchildren may. 

Another interesting thought to ponder is that “wealth” is valued at the margin. People’s assets are always priced based on the last trade. When the stock market dropped 50% in 2008-2009, wealth was temporarily destroyed. When the 1970’s inflation caused interest rates to rise substantially, fixed income values dropped but principal ultimately was returned. However, purchasing power was permanently destroyed. If housing prices do not rise, wealth is eroded by the interest paid on the mortgage. Leverage increases wealth only if the borrowed money is invested with a higher return than the cost of that debt. As we have just witnessed, that “last trade” can produce a very harsh reality and its impact is often underestimated by the optimists, but overemphasized by the pessimists. But, the last trade becomes a moot point for the true equity investor who is patient. If one does not need to sell, the last trade is essentially meaningless except that it may make one feel nervous and less wealthy. What is truly important is having enough income to meet one's requirements and to have enough safe assets to take care of needs while the “last trade” is unrealistically low. Today we live in an environment where most people are looking at the last trade and wondering what will happen next. This is understandable and part of human behavior, for that is how we learn. It is also very hard to trust that eventually conditions will normalize, because eventually may be a long time off. 

We believe that if we could fast-forward to the latter part of this decade, we would find the following. Interest rates will be higher, but not so high that they would be unmanageable. Short term rates will have risen more than long rates, flattening the yield curve, and savers will welcome these higher rates. Investors will have increased their allocations to equities during the early part of the decade, only to move some of their gains to bonds as rates rise. Baby boomers especially will probably shift more of their assets to bonds when they are able to earn more income. Until then, they will likely stay invested in equities because dividends alone are paying more income than shorter term bonds. We probably will have gone through a recession which although unpleasant, tempers inflation expectations and is a welcome governor to excessive growth. Commodity price inflation will have abated because ever increasing material prices will eventually choke off growth. Today’s flow of capital to emerging markets will have slowed to a more manageable level as some semblance of normal will have returned to the balance between emerging and developed markets. It will not be at all surprising if there were some hiccups in the emerging markets during the decade. Even today, some countries are instituting controls to try to stem the flow of capital into their countries in order to avoid creating a bubble. The US dollar will probably be stronger since inflation in emerging markets should eventually drive their currencies lower. 

The biggest threat and opportunity to our future probably lies in how the US deals with its budget deficit and overall debt. The good news is that the debate is intensifying and it appears that nothing is off the table. The bad news is that Democrats and Republicans have very different ideas about revenues, expenditures and the size of government. The overall debt level is quickly reaching a point where it becomes untenable which will force very painful solutions. During the past 60 years, the Federal Budget operated with the following averages (expressed as % of GDP): Expenditures = 19.7%; Revenues = 17.7%; Deficit = 2.0%. Current Congressional Budget Office (CBO) projections through 2016 show Expenditures running at 22.5% of GDP and Revenues at 19.3%. There have been only five years between 1950 and 2008 when expenditures exceeded 22% of GDP, and they were all between 1982 and 1990. If expenditures are not reduced, we believe that it is unlikely GDP will grow at the rate the CBO projects. The estimated 2011 budget deficit of 10.9% of GDP is clearly unsustainable and while 2-3% may be, our concern is that revenues will not grow as rapidly as expected, and/or expenditures will not fall as quickly as expected. 

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This leads us to conclude that this issue more than any other, will be the single most important issue for the future health of the US. Our total debt exceeds $14 trillion with more than $5 trillion maturing within 4 years. If interest rates were to rise materially, interest costs alone will blow a large hole in the official estimates. While the deficit is certainly one concern, a secondary concern is the overall size of the government sector. The CBO estimates suggest that government spending will take another two percentage points of GDP on average versus what the country has experienced over the past 60 years, and over four percentage points over what government spending was during the 1950 through 1975 period. This is a major shift in the role and impact of government and calls into question whether the private sector can generate enough revenue to sustain these expenditures. Our belief is that “reversion-to-the-mean” will bring these averages more into alignment with historical norms. Our concern is that the pain that will be required to do so will push its timing far into the future. But, our expectation is that the discipline of the financial markets will force a reasonable and realistic solution relatively soon. In summary, we recognize the challenges that we are all facing. Uncertainty abounds and easy solutions to problems are nonexistent. It will take thoughtful analysis and planning, a willingness of all parties to participate genuinely in the debate, and shared sacrifice for us all to move forward.

As we survey the investment landscape, our outlook is succinct. Currently, cash assets provide little more than liquidity and some modest peace of mind during volatile market environments. Fixed income securities have been the beneficiaries of a 30 year bull market of declining interest rates and do not provide inflation protection. Commodity prices have soared due to demand from fast growing emerging markets, a weaker dollar and investors allocating funds to this asset class. History has shown us that the cure for high commodity prices is high commodity prices – supply is either increased or demand is destroyed. Real estate is in the midst of what will likely be a lengthy process of recovery. In light of this backdrop, we strongly believe that investing in well managed, high quality companies will provide investors with the best chance of successfully navigating these uncharted waters.

Our confidence in our portfolio companies reflects their competitive advantages, the streams of cash flows they generate and their ability to pay and grow dividends. To us, trying to determine what the next news item will be or whether a company will miss their next quarter’s earnings estimate is not investing. Investing is having confidence in a company’s ability to produce a reasonable level of earnings and in our ability to properly value those earnings. While the market gyrates between greed and fear, the true investor will simply ride the waves up and down with the knowledge that he or she is still on course.