November 18, 2005
To Our Investors and Friends
To paraphrase Dickens: These are the best of times for investors… and these are the worst of times for investors. Corporate profits are strong, unemployment is low, productivity continues to climb, interest rates are still low, and consumers have continued to buy. On the other hand, neither equities nor bonds are providing returns close to historical expectations. U.S. fiscal and trade deficits are at levels that seem unsustainable without significantly higher interest rates; personal saving rates are at all-time lows; energy costs seem at times to be out of control; major home builders say that new home sales are softening; inflation is rearing its head; and consumer confidence is volatile.
Despite this confusing dichotomy, we have concluded that it is reasonable for us to remain nearly fully invested in that certain group of equities in which we specialize, i.e., those that (1) have long track records of generating strong internal returns on invested capital; (2) are conservatively valued on the basis of projected operating profit growth; and (3) consistently reinvest operating cash flows in high-yield operating assets through capital spending and acquisitions, or return free cash flows to their investors, through consistent dividends and/or stock buybacks.
In our view, this formula is the most secure way of generating equity yields that consistently exceed the S&P 500 benchmark, over time. While some of the economic concerns outlined above may depress equity markets and essentially “lower all boats” for some period of time, companies that consistently deliver strong returns on invested capital and either reinvest or return free cash flows for their investors, create real economic value, which will be borne out through both “thick and thin” market conditions.
Having said that, we still believe that Warren Buffett was correct several years ago, when he said that his return expectation for the equity markets was “six to eight percent over the next decade or two”. This would mean that achieving a compound yield of eight to ten percent in this period would be very attractive. In that regard, since we believe that the resolution of the economic dichotomy outlined above will almost certainly be significantly higher long-term interest rates, investing a small percentage of our assets in selective fixed-income securities might be in order sometime in the next few years. For the moment, we are confident in our strategy of remaining invested in properly valued, economic-value producing equities. We will continue to take some profits as we go along, and may accumulate some cash when we perceive that long-term rates are moving toward a level that we might consider interesting.
As always, we appreciate your questions and observations.
Friday, November 18, 2005
Monday, May 16, 2005
Client Letter - 5/16/05
May 16, 2005
To Our Investors and Friends:
In recent weeks, we have watched with considerable interest the continuing financial decline of the U.S. automobile industry. It is hard to imagine that the vast debt obligations of General Motors and Ford are now rated “junk” by Standard & Poor’s. Yet, given our investment discipline, i.e. our requirement for each company’s internal rate of return on invested capital (ROIC) to exceed its cost of capital, this makes perfect sense. The auto industry (along with several others, such as airlines) has historically been unable to produce ROIC that even approximates their capital costs. That kind of underperformance, literally the destruction of value over many years, can ultimately only result in failure.
The reverse of this situation, i.e. owning only companies that consistently produce superior ROIC, gives us a great deal of confidence, even in the kind of lackluster market we are currently experiencing (the S&P 500 Index is down 4.8 % year-to-date and down 18.8 % for the last 5-years). History (plus our own investment results) has shown us that companies which consistently create value for their shareholders outperform the market, over time. For this reason, as well as our long-term confidence in the USA, we are comfortable being nearly fully invested, at this time.
This is not to say, of course, that we are unconcerned about U.S. macro-economic trends. Steadily increasing fiscal and trade deficits, as well as historically low saving rates, have created a virtual certainty that something (namely interest rates) has eventually got to give. As rates increase, coupled with higher oil prices, several areas of the economy, such as autos, housing and some retailers, are likely to experience a downturn, despite the fact that the current micro-economic climate, including such things as employment and capital spending, may stay reasonably strong.
Because of these concerns, we continue to position ourselves defensively within our overall ROIC strategy. For example, we have significant positions in food companies, dividend-paying companies, and companies that provide a hedge against a weakening U.S. dollar. As the year progresses, we may sell certain positions, either to lock-in profits, redeploy capital in more defensive, dividend-paying names, or simply to increase cash, allowing us to be opportunistic. Overall, however, it is our intention to remain substantially invested in companies meeting our ROIC criteria.
As always, we welcome your observations and/or questions.
To Our Investors and Friends:
In recent weeks, we have watched with considerable interest the continuing financial decline of the U.S. automobile industry. It is hard to imagine that the vast debt obligations of General Motors and Ford are now rated “junk” by Standard & Poor’s. Yet, given our investment discipline, i.e. our requirement for each company’s internal rate of return on invested capital (ROIC) to exceed its cost of capital, this makes perfect sense. The auto industry (along with several others, such as airlines) has historically been unable to produce ROIC that even approximates their capital costs. That kind of underperformance, literally the destruction of value over many years, can ultimately only result in failure.
The reverse of this situation, i.e. owning only companies that consistently produce superior ROIC, gives us a great deal of confidence, even in the kind of lackluster market we are currently experiencing (the S&P 500 Index is down 4.8 % year-to-date and down 18.8 % for the last 5-years). History (plus our own investment results) has shown us that companies which consistently create value for their shareholders outperform the market, over time. For this reason, as well as our long-term confidence in the USA, we are comfortable being nearly fully invested, at this time.
This is not to say, of course, that we are unconcerned about U.S. macro-economic trends. Steadily increasing fiscal and trade deficits, as well as historically low saving rates, have created a virtual certainty that something (namely interest rates) has eventually got to give. As rates increase, coupled with higher oil prices, several areas of the economy, such as autos, housing and some retailers, are likely to experience a downturn, despite the fact that the current micro-economic climate, including such things as employment and capital spending, may stay reasonably strong.
Because of these concerns, we continue to position ourselves defensively within our overall ROIC strategy. For example, we have significant positions in food companies, dividend-paying companies, and companies that provide a hedge against a weakening U.S. dollar. As the year progresses, we may sell certain positions, either to lock-in profits, redeploy capital in more defensive, dividend-paying names, or simply to increase cash, allowing us to be opportunistic. Overall, however, it is our intention to remain substantially invested in companies meeting our ROIC criteria.
As always, we welcome your observations and/or questions.
Monday, January 10, 2005
Client Letter - 1/10/05
January 10, 2005
To Our Investors and Friends:
The performance of the stock market in 2004 may well be a preview of how we can expect markets to behave over the next several years. By long-term historical standards, the broader market represented by the S&P 500 performed well, with a return of 9%. The narrower Dow Jones Industrial Average returned only 3.5%, due largely to fallout from the pharmaceutical industry. Last year’s market factors, such as low interest rates, large deficits, a weakening dollar, higher oil prices and an emotional presidential election all contributed to tempered growth in the economy and stock market. Although these factors are certain to change, the result will most likely be modest, yet satisfactory, gains in the economy and the stock market over the next several years.
Resolving uncertainty is the largest issue when looking at future stock market returns. During the latter half of 2004, the market was given the certainty of a Federal Reserve committed to raising short-term interest rates due to signs of solid growth in the economy. In addition, a long and emotional presidential campaign came to a clear and undisputed end. In fact, the market achieved almost 80% of its 2004 return after November 2nd. The need for a weaker U.S. dollar also became clear, in the face of growing fiscal and trade deficits. This was clearly affirmed by Alan Greenspan on November 19th when he said: “International investors will eventually adjust their accumulation of dollar assets, elevating the cost of financing the U.S. current account deficit.” This realization has in fact lifted the stock market with expectations of a short-term increase in exports for U.S. manufacturing corporations. While the ongoing positive and negative impacts of these events are debatable, they allowed markets to rationalize. In the absence of terrorism inside our borders, they led to positive economic and market returns.
As we enter 2005, we can begin to see the challenges and uncertainties that lie ahead. What will be the result of the Bush fiscal policy and the towering fiscal and trade deficits? Will international investors continue to overcome the risk of a weak dollar for the safety of the “risk-free” U.S. government bond, or opt for attractive relative U.S. asset prices due to their stronger currencies? Or will a continued decline of the dollar lead to higher interest rates, slower economic growth, higher unemployment, and a weakened consumer? Our guess is that the potential growth of the economy is certainly limited by these risks, but by no means stifled. With long-term interest rates starting the year near historically low levels, and the unemployment rate at a relatively healthy 5.4%, the economy has a strong foundation to maintain stable growth into 2005. With a wary eye toward the war on terror, we feel this environment, though challenging, provides an excellent opportunity to employ our investment management discipline.
Our holdings have outperformed the market this year and we are quite comfortable being significantly deployed in stocks at this time. Our holdings, for the most part, are conservative and dividend paying. GE (our largest holding), General Mills, Kellogg, ConAgra, Johnson & Johnson and J.P. Morgan Chase are good examples. We have also made a particular effort to take positions that are likely to benefit from a weaker dollar; for example, Berkshire Hathaway, PNC Financial and U.S. Bank. As in 2004, we expect to continue taking some of the significant gains in our portfolio as the year progresses. We have several other investments that we plan to make and we expect to have cash available to be opportunistic when the time is right.
As always, we enjoy your questions and comments. Happy New Year!
To Our Investors and Friends:
The performance of the stock market in 2004 may well be a preview of how we can expect markets to behave over the next several years. By long-term historical standards, the broader market represented by the S&P 500 performed well, with a return of 9%. The narrower Dow Jones Industrial Average returned only 3.5%, due largely to fallout from the pharmaceutical industry. Last year’s market factors, such as low interest rates, large deficits, a weakening dollar, higher oil prices and an emotional presidential election all contributed to tempered growth in the economy and stock market. Although these factors are certain to change, the result will most likely be modest, yet satisfactory, gains in the economy and the stock market over the next several years.
Resolving uncertainty is the largest issue when looking at future stock market returns. During the latter half of 2004, the market was given the certainty of a Federal Reserve committed to raising short-term interest rates due to signs of solid growth in the economy. In addition, a long and emotional presidential campaign came to a clear and undisputed end. In fact, the market achieved almost 80% of its 2004 return after November 2nd. The need for a weaker U.S. dollar also became clear, in the face of growing fiscal and trade deficits. This was clearly affirmed by Alan Greenspan on November 19th when he said: “International investors will eventually adjust their accumulation of dollar assets, elevating the cost of financing the U.S. current account deficit.” This realization has in fact lifted the stock market with expectations of a short-term increase in exports for U.S. manufacturing corporations. While the ongoing positive and negative impacts of these events are debatable, they allowed markets to rationalize. In the absence of terrorism inside our borders, they led to positive economic and market returns.
As we enter 2005, we can begin to see the challenges and uncertainties that lie ahead. What will be the result of the Bush fiscal policy and the towering fiscal and trade deficits? Will international investors continue to overcome the risk of a weak dollar for the safety of the “risk-free” U.S. government bond, or opt for attractive relative U.S. asset prices due to their stronger currencies? Or will a continued decline of the dollar lead to higher interest rates, slower economic growth, higher unemployment, and a weakened consumer? Our guess is that the potential growth of the economy is certainly limited by these risks, but by no means stifled. With long-term interest rates starting the year near historically low levels, and the unemployment rate at a relatively healthy 5.4%, the economy has a strong foundation to maintain stable growth into 2005. With a wary eye toward the war on terror, we feel this environment, though challenging, provides an excellent opportunity to employ our investment management discipline.
Our holdings have outperformed the market this year and we are quite comfortable being significantly deployed in stocks at this time. Our holdings, for the most part, are conservative and dividend paying. GE (our largest holding), General Mills, Kellogg, ConAgra, Johnson & Johnson and J.P. Morgan Chase are good examples. We have also made a particular effort to take positions that are likely to benefit from a weaker dollar; for example, Berkshire Hathaway, PNC Financial and U.S. Bank. As in 2004, we expect to continue taking some of the significant gains in our portfolio as the year progresses. We have several other investments that we plan to make and we expect to have cash available to be opportunistic when the time is right.
As always, we enjoy your questions and comments. Happy New Year!
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