For everyone who follows this blog, you know we have continually set forth the fundamental economic problems that burden the global economy. Excessive leverage and the uncomfortable consequences of reducing that leverage top the list. We have studied similar events in history to learn what could go wrong, as well as what could go right. We have stayed conservative since 2008, with a healthy cash position. Our stock and bond holdings have done very well during the recovery phase, surpassing our expectations.
Remember, our number one focus for the past year has been simple: invest conservatively to preserve capital, allowing for investment at a better time and price. After a relentless and unprecedented “bull” market for the last 14 months, investors are finally appreciating risk again. We welcome this change.
An appreciation for risk is exactly what allowed us to buy investment-grade corporate bonds in late 2008 and early 2009 at yields-to-maturity ranging from 8% to 12%. An appreciation for risk is what allows us to buy EVA companies with 3% to 5% dividend yields at reasonable prices. An appreciation for risk benefits the patient and conservative investor.
If people now question everything from whether markets are “rigged” to complete Armageddon in the global economy, then that is a change for the better. It is a shift in investor psychology that we have been expecting for some time. Without a healthy dose of skepticism, conscientious investors have no chance. Attention to risk does not spell disaster. It opens up opportunity.
Could markets go lower? Yes. Could we have market instability from “machine” trading? Yes. Do we face challenges from Europe, an over-indebted Japan, a bubble in China, persistent deficits and higher taxes at home? Yes. Those are issues we study every single day. They matter greatly to us and have kept us cautious. We factor them into the prices we are willing to pay. But there are solutions to each problem that are difficult but not catastrophic. The issues are clearly on the table and voted on every day in the market. Beyond those solutions we have a fundamental belief in the “going-concern”.
“Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.”
-Warren Buffett, Shareholder Letter, 2007
Households will always seek to maximize wealth and consumption, making the most of the resources available. Behavior won’t always be rational or predictable, but markets allow for our society to proceed in the most efficient way possible. Mistakes are made and corrected, confidence will rise and fall, and capital will be misallocated only to be reallocated. Politics and power will interfere, but society will continually pursue a better outcome. There is opportunity to invest for that future. If we didn’t believe in that, we would resign our role as investment managers to live on a farm near a reliable source of water and grow our own food.
Every doomsayer or perma-bear I know of at least acknowledges the going-concern concept and the fact that difficult issues can and will be resolved. In valuation analysis it is often called “terminal value”. That is an oxymoron because it actually represents continuing value. It measures what an asset is worth into perpetuity. While we don’t know exactly how the issues of today will be resolved and we expect it to be uncomfortable at times, markets need to simultaneously appreciate both risk and going concern.
For several months now risk has been underappreciated. It is indeed good to see assets start to re-price, even if our holdings are somewhat negatively affected. Since the market surpassed our expectations last year, it does not surprise us to see some of those gains retraced.
What is important is that we are here to take advantage of better prices as they develop. We have been prepared for a change in market character.
Expect us to maneuver by trimming certain positions into rallies and making investments in core EVA holdings at lower prices. Protecting capital is still our main priority today in an uncertain world, but our long-term goal is to make money and generate wealth for our clients. We are encouraged to see that goal come into focus. Don’t get me wrong, we can be as bearish as anyone; it is in our nature to be conservative. Much of what we are dealing with is slow to develop, requires patience, and a watchful eye. Just give us good value at a price that appreciates risk, and we can do more than just wait. That is good news.
Peter J. Falker, CFA
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