Friday, January 04, 2013

The Case for Stocks in 2013

Happy New Year everyone!

Time Magazine’s cover story, in their November 26, 2012, issue proclaimed, in huge, bold-faced type:  “WHY STOCKS ARE DEAD (And Bonds Are Deader)”.  Headlines like that scare a lot of people, especially when they are being bombarded from all sides with doomsday articles on the so-called “fiscal cliff” and all the dire things that were going to happen when we were supposedly going over it.

If, as Time proclaimed, bonds are even deader than stocks, how are we supposed to invest our money?  Are we to leave it in cash with money market yields at essentially zero?  Well, you had to read all the way to the fourth-page ending of the article to learn that the protagonists of the story, Bill Gross and Mohamed El-Erian of PIMCO Investments, are buying blue-chip stocks rather than bonds (their primary business).  According to El-Erian and Gross: “Blue chips have become the new bonds.  Multinational franchise firms… can spread risk around the world while delivering a 3% inflation-beating dividend…. Well-capitalized growing firms that are undervalued because they are in beleaguered markets are also smart plays.”  So, the conclusion of the Time article is the exact opposite of the bold-faced headline.

When all is said and done, the shares of strong, undervalued companies are perennially the best investments.  And that’s exactly what we have said and done for years.  We look for companies that create economic value by perennially producing returns on invested capital that exceed their costs of capital and look to buy them when they are undervalued.  Buying and holding stocks has been difficult, at times, in the last 10-12 years but, during that long and sometimes unsettled period, it has been, and continues to be, the right way to invest.

In the context of the daily news cycle, it is good to step back and remember where we are economically at the moment.  In their 2009 book “This Time is Different”, Reinhart and Rogoff demonstrated statistically that financial-panic induced recessions historically have a long tail of approximately seven years.  Beginning in late 2007, we have just been through the worst financial panic since the great depression, so statistically we should not expect our difficult economic conditions to fully abate until sometime in 2014 or 2015.  And that’s about how it feels.  Unemployment is gradually improving, but it looks like it will remain high for several years to come.  The housing market, while a bit better, is still soft.  Automotive and retail sales remain slow and inflation is non-existent, at times bordering on deflation.  Households continue to relentlessly pay down their debt, which is theoretically a good thing but, when you’re paying down debt, you put off major purchases, such as cars and houses for several years (perhaps to 2014 or 2015).  So, while corporate profits are gradually improving, it is unlikely that they will become really robust for several years to come.  In the meantime, shares of good companies can be expected to remain reasonably stable and dividends should generally be secure, as the economy continues to slowly improve.

Finally, as we have expected for several months, the United States did not go over the fiscal cliff, despite the horrid prognostications of the national (and international) press.  Of course, much more remains to be done in cutting spending to reduce the deficit, so we can expect a lot of political posturing and nay-saying throughout the coming year.  Nonetheless, everyone should keep in mind that the United States of America is not having any problem funding its debt obligations at historically low interest rates.  That is primarily because the debt of the United States is safer by far than the sovereign debt of any other country in the world.  So, we are not Greece (or Italy or Spain) and debt Armageddon is not upon us just yet, despite the cries of the far right during our recently concluded presidential campaign.

In conclusion, here is the last paragraph of our blog two years ago, at the end of December 2010:

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.


Happy New Year,

Jack and Peter Falker

January 4, 2013