November 20, 2003
To Our Investors and Friends:
The markets have moved up this year for two reasons: First, we had a euphoric war rally, which started in the weeks just before we invaded Iraq; and, second, we have had the beginning of an economic recovery, which is at least partially related to next year’s presidential election. Year-to-date, the S&P 500 Index is up approximately 17.5%, a little more than half-way to recovering the losses it incurred last year (a loss of 23.4% in 2003 requires a gain of 30.5% to break-even).
It is conventional wisdom that, somehow, a war is good for the stock market, perhaps because it replaces the anxiety of anticipation with greater certainty and direction. It also represents the “vortex” of the so-called high risk/reward scenario. In the early going, at least, the war went “as planned”, and the market rise seemed justified. We had been very conservative in the year leading up to the war, successfully protecting client capital from the worst year so far in the secular bear market. Our decision was to not take the high-risk/reward proposition, and instead wait for a more comfortable entry point. Given our focus on long-term performance, we considered it worth the risk of missing a “war rally”. As it turns out, much of this rally continues to ride on high-beta (i.e. high-risk) equities, while many of the stocks we follow (lower beta, value-creating companies) have been left behind and still present potentially good opportunities.
After enduring a summer of rather downbeat economic news, the market has continued higher in hopes of a late 2003 recovery, which is what we are seeing, despite a lack of strong jobs growth. Investors have poured money into cyclical stocks, those that benefit from the early stages of economic growth. Many of these have reached levels well above fair value. Because much of this economic recovery is the result of a huge fiscal stimulus, which along with Iraq is contributing to significant deficit spending, there is reason to believe that the recovery may not be sustainable in the longer term, particularly as inflation resurfaces and interest rates rise. For the moment, however, with an election year ahead of us, it is likely that the Federal Reserve and the White House can keep the recovery alive and possibly even re-create some of the several million jobs that have been lost. This has given us a real opportunity to begin reinvesting cash that has been kept in safekeeping.
Our portfolio opportunities are focused generally on protective stocks that generate high value creation and good dividends, and which are seemingly out of favor at the moment. Examples include General Mills, General Electric, ConAgra, Johnson & Johnson, and TCF Financial. We are also seeking good valuation in proven growth companies such as Medtronic and UnitedHealth Group. We will not rush to invest cash in hopes of catching up with this year’s “beta-chasing” or “cyclical” rallies. None of our holdings will deviate from our strategy of investing in companies with consistently good returns on capital and reasonable valuations.
We continue to be very careful about what we do. As we return to greater normalcy (and we do hope that’s the case) we will see, at various times, the market declining, rallying, and rotating among sectors. However, given the mix of economic uncertainty, the obvious threats of global terrorism, and the high level of stock market speculation, the significant volatility of the past several years is likely to continue. We have endured the early stages of this secular bear market through capital preservation. That is the single most important element to outperforming the market in the long term. There will be more rallies and sector rotations to come, and we will look to our investment discipline to guide us.
Best wishes for a good holiday season,
Thursday, November 20, 2003
Thursday, August 21, 2003
Client Letter - 8/21/03
August 21, 2003
To Our Clients and Friends:
The world seems to be returning to more normal circumstances, now that concerns about Iraq and terrorism have at least partially diminished and the U.S. economy is staging the beginnings of a comeback. To be sure, there are many geopolitical and economic concerns (such as deflation), but it is hard to say when or how severely some of these problems might impact us. Simple logic tells us that there is more terrorism to come, and that we are not out of the economic woods. For that reason, we would describe our current situation as being on the ragged edge of normalcy.
By the same token, this condition we have described tells us that the equity markets have greatly over-reacted to the situation at hand, particularly in the technology sector, and that these “semi-normal” conditions dictate a pull back from the current re-inflation of the equity bubble, to more normal valuation levels. This will allow investors to earn reasonable market returns, based on the fundamental principle of sustainable earnings growth. In other words, if we indeed are returning to normal market conditions, stocks will resume moving up and down based on real earnings and cash flow, not euphoria and speculation. For the most part, that hasn’t happened yet.
In an August 11th article entitled, “Doesn’t Value Matter Anymore?” Richard Bernstein, chief equity strategist of Merrill Lynch, writes: “The speculative nature of the stock market is again damaging the economy as it did during the bubble. Capital is again being misallocated within the economy…. We have repeatedly pointed out that today investors are paying to take risk rather than demanding compensation. Our newest research further confirms our earlier findings that investors are acting as though value does not matter anymore.”
Within this complex environment, we are proceeding very carefully. First, we are very mindful of our success in conserving our clients’ capital over the last two years and we do not want to take undue risk with that capital in this environment. On the other hand, risk-free U.S. Treasury money-market returns are at unacceptably low levels. To deal with this dilemma, we are following a strategy that calls for investing a portion of our managed assets in a small group of very substantial companies that are either fairly or under-valued, based on our well-developed modeling discipline. All of these companies provide dividend returns that are higher than money market yields and offer appreciation potential, over time, based on their current valuations. In that regard, we view them as being safe and even somewhat “bond-like”, since for the most part they provide yields comparable with 5-10 year bonds and their “principal” is virtually safe over time. If the market moves down (which it eventually will if “normalcy” truly is returning) we will make further investments in these companies to average down our price. If market euphoria continues, which it may through the rhetoric of the 2004 presidential election, we may take profits or we may simply hold on and continue collecting the dividends.
We believe that our current strategy will allow us to outperform the S&P 500 index, over time. We may under perform a bit in the short term, because we are protecting client capital, but in the long term we will outperform the index, as we have consistently been able to do, since our inception. In this regard, it is important to recognize that the S&P 500’s loss of 23% in 2002 requires a subsequent gain of 30% just to break even. On the other hand, not having taken those kinds of losses last year allows us to carefully move forward, as described above.
Please let us know if we can further explain our strategy, or provide additional reading material on current economic and market conditions.
To Our Clients and Friends:
The world seems to be returning to more normal circumstances, now that concerns about Iraq and terrorism have at least partially diminished and the U.S. economy is staging the beginnings of a comeback. To be sure, there are many geopolitical and economic concerns (such as deflation), but it is hard to say when or how severely some of these problems might impact us. Simple logic tells us that there is more terrorism to come, and that we are not out of the economic woods. For that reason, we would describe our current situation as being on the ragged edge of normalcy.
By the same token, this condition we have described tells us that the equity markets have greatly over-reacted to the situation at hand, particularly in the technology sector, and that these “semi-normal” conditions dictate a pull back from the current re-inflation of the equity bubble, to more normal valuation levels. This will allow investors to earn reasonable market returns, based on the fundamental principle of sustainable earnings growth. In other words, if we indeed are returning to normal market conditions, stocks will resume moving up and down based on real earnings and cash flow, not euphoria and speculation. For the most part, that hasn’t happened yet.
In an August 11th article entitled, “Doesn’t Value Matter Anymore?” Richard Bernstein, chief equity strategist of Merrill Lynch, writes: “The speculative nature of the stock market is again damaging the economy as it did during the bubble. Capital is again being misallocated within the economy…. We have repeatedly pointed out that today investors are paying to take risk rather than demanding compensation. Our newest research further confirms our earlier findings that investors are acting as though value does not matter anymore.”
Within this complex environment, we are proceeding very carefully. First, we are very mindful of our success in conserving our clients’ capital over the last two years and we do not want to take undue risk with that capital in this environment. On the other hand, risk-free U.S. Treasury money-market returns are at unacceptably low levels. To deal with this dilemma, we are following a strategy that calls for investing a portion of our managed assets in a small group of very substantial companies that are either fairly or under-valued, based on our well-developed modeling discipline. All of these companies provide dividend returns that are higher than money market yields and offer appreciation potential, over time, based on their current valuations. In that regard, we view them as being safe and even somewhat “bond-like”, since for the most part they provide yields comparable with 5-10 year bonds and their “principal” is virtually safe over time. If the market moves down (which it eventually will if “normalcy” truly is returning) we will make further investments in these companies to average down our price. If market euphoria continues, which it may through the rhetoric of the 2004 presidential election, we may take profits or we may simply hold on and continue collecting the dividends.
We believe that our current strategy will allow us to outperform the S&P 500 index, over time. We may under perform a bit in the short term, because we are protecting client capital, but in the long term we will outperform the index, as we have consistently been able to do, since our inception. In this regard, it is important to recognize that the S&P 500’s loss of 23% in 2002 requires a subsequent gain of 30% just to break even. On the other hand, not having taken those kinds of losses last year allows us to carefully move forward, as described above.
Please let us know if we can further explain our strategy, or provide additional reading material on current economic and market conditions.
Monday, March 31, 2003
Client Letter - 3/31/03
March 31, 2003
To Our Clients and Friends:
Nearly every press report we see about the stock market these days attributes its performance, whether up or down, to the war in Iraq. That could be right, in the very short term, based on the emotional ups and downs that drive mass-market psychology. However, with a time horizon of more than just a few weeks, it is corporate earnings and the overall economy, not the war, which will continue to drive the markets.
For example, it is not the war that has caused corporate CEOs to curtail capital spending for the last three years; it’s not the war that has caused increased unemployment and consumer sentiment that has fallen to its lowest level in ten years; it’s not the war that has caused consumer credit to reach new (and very dangerous) highs; and it is not the war that has caused housing starts to fall. These are all signs of an economy, burdened with the excesses of the late 1990s, that continues to teeter on the brink of a double-dip recession.
Nonetheless, stocks remain historically expensive, despite a market correction that has been ongoing for more than three years. The price/earnings ratio (P/E) of the S&P 500 index, based on trailing 12 month earnings, is above 30, compared with historic norms of less than 20 (during the last gulf war it was 18). This valuation dichotomy continues, despite the fact that the predictability of corporate earnings growth in the United States is the lowest in more than 60 years (since 1941 and another war), based on statistics kept by Merrill Lynch.
These are not statistics that signal the start of a new bull market. On the contrary, they quite forcefully indicate that the valuation bubble of the late 1990s is still with us, and that this condition must be corrected before a sustainable move up in the market can begin.
In his recently issued annual report, Warren Buffett made the following observation:
“We continue to do little in equities…. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us…. The aversion to equities that (we) exhibit today is far from congenital. We love owning common stocks--if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pretax returns… we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity."
Like Buffett, we too love owning common stocks, but we insist on buying them at prices that will produce acceptable long-term returns. Our own intensive valuation work tells us that the time is not yet right, even though we thoroughly dislike accepting 1% yields while we wait. However, by holding short-term treasury securities, we are very confident that the capital of our clients is being preserved for the moment when stocks again become attractive.
Best regards
To Our Clients and Friends:
Nearly every press report we see about the stock market these days attributes its performance, whether up or down, to the war in Iraq. That could be right, in the very short term, based on the emotional ups and downs that drive mass-market psychology. However, with a time horizon of more than just a few weeks, it is corporate earnings and the overall economy, not the war, which will continue to drive the markets.
For example, it is not the war that has caused corporate CEOs to curtail capital spending for the last three years; it’s not the war that has caused increased unemployment and consumer sentiment that has fallen to its lowest level in ten years; it’s not the war that has caused consumer credit to reach new (and very dangerous) highs; and it is not the war that has caused housing starts to fall. These are all signs of an economy, burdened with the excesses of the late 1990s, that continues to teeter on the brink of a double-dip recession.
Nonetheless, stocks remain historically expensive, despite a market correction that has been ongoing for more than three years. The price/earnings ratio (P/E) of the S&P 500 index, based on trailing 12 month earnings, is above 30, compared with historic norms of less than 20 (during the last gulf war it was 18). This valuation dichotomy continues, despite the fact that the predictability of corporate earnings growth in the United States is the lowest in more than 60 years (since 1941 and another war), based on statistics kept by Merrill Lynch.
These are not statistics that signal the start of a new bull market. On the contrary, they quite forcefully indicate that the valuation bubble of the late 1990s is still with us, and that this condition must be corrected before a sustainable move up in the market can begin.
In his recently issued annual report, Warren Buffett made the following observation:
“We continue to do little in equities…. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us…. The aversion to equities that (we) exhibit today is far from congenital. We love owning common stocks--if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pretax returns… we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity."
Like Buffett, we too love owning common stocks, but we insist on buying them at prices that will produce acceptable long-term returns. Our own intensive valuation work tells us that the time is not yet right, even though we thoroughly dislike accepting 1% yields while we wait. However, by holding short-term treasury securities, we are very confident that the capital of our clients is being preserved for the moment when stocks again become attractive.
Best regards
Thursday, December 12, 2002
Client Letter - 12/12/02
December 12, 2002
To Our Investors and Friends:
“…I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present…. That method of valuation is exactly what should be used…. If I can’t do that, then I don’t buy. So I’ll wait.”
Warren Buffett
Like Warren Buffett, we’ll wait. Despite what politicians and media pundits would like everyone to believe, market valuations are at unreasonably high levels, made worse by the run-up in the markets since mid-October. Nonetheless, market trend-lines continue pointing downward, with the S&P 500 index down 21.2% year-to-date.
Essentially, what we are experiencing are “bear market rallies,” within the context of what appears to be a secular bear market, quite similar to what we experienced from 1964 to 1982, when the markets fluctuated wildly but ended up approximately where they began 18 years earlier. Within that context, the buy and hold concept aggressively marketed by the securities industry simply doesn’t work. Investors who made handsome profits during the 1964 to 1982 secular bear market understood what constituted real valuation (as described above by Warren Buffett) and bought and sold accordingly. In recent experience, the best evidence of this is the fact that cash invested in a money market fund has outperformed cash invested in an S&P 500 index fund for more than 5 ½ years now. In other words, to make money in the market over the last 5 ½ years you had to astutely buy and sell, in direct opposition to what the securities industry was telling you to do.
We continue to believe that equities are the investment asset class of choice for the long term. As always, however, it is necessary to know when to astutely buy and sell. That is what our valuation modeling work helps us do, and we have acted accordingly throughout the difficult market environment of 2002. This has allowed us to significantly outperform the markets. At the moment, nearly all of our accounts are at least 85% in cash, which is invested totally in U.S. Treasury securities. In that regard, during the past few weeks, we have eliminated all investments in money market funds that hold corporate commercial paper, because of a very uncertain and potentially deflationary economic environment, as well as the continuing high probability of both war and terrorist events.
We have identified a growing number of EVA companies that we expect to own, based on our valuation modeling and in-person management visits, during which we have been able to further validate our modeling analyses. When we believe the time is right, we will own many of these companies. At the moment, however, we believe our clients will continue to be rewarded by our current strategy of staying substantially in cash investments.
We continue to make an effort to speak with our clients personally as often as possible. We have several good analytical articles about the current status of the markets that we are sharing with people as we meet. If you would like to read any of these articles, or have questions for either of us, please let us know.
We wish you a Happy Christmas.
To Our Investors and Friends:
“…I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present…. That method of valuation is exactly what should be used…. If I can’t do that, then I don’t buy. So I’ll wait.”
Warren Buffett
Like Warren Buffett, we’ll wait. Despite what politicians and media pundits would like everyone to believe, market valuations are at unreasonably high levels, made worse by the run-up in the markets since mid-October. Nonetheless, market trend-lines continue pointing downward, with the S&P 500 index down 21.2% year-to-date.
Essentially, what we are experiencing are “bear market rallies,” within the context of what appears to be a secular bear market, quite similar to what we experienced from 1964 to 1982, when the markets fluctuated wildly but ended up approximately where they began 18 years earlier. Within that context, the buy and hold concept aggressively marketed by the securities industry simply doesn’t work. Investors who made handsome profits during the 1964 to 1982 secular bear market understood what constituted real valuation (as described above by Warren Buffett) and bought and sold accordingly. In recent experience, the best evidence of this is the fact that cash invested in a money market fund has outperformed cash invested in an S&P 500 index fund for more than 5 ½ years now. In other words, to make money in the market over the last 5 ½ years you had to astutely buy and sell, in direct opposition to what the securities industry was telling you to do.
We continue to believe that equities are the investment asset class of choice for the long term. As always, however, it is necessary to know when to astutely buy and sell. That is what our valuation modeling work helps us do, and we have acted accordingly throughout the difficult market environment of 2002. This has allowed us to significantly outperform the markets. At the moment, nearly all of our accounts are at least 85% in cash, which is invested totally in U.S. Treasury securities. In that regard, during the past few weeks, we have eliminated all investments in money market funds that hold corporate commercial paper, because of a very uncertain and potentially deflationary economic environment, as well as the continuing high probability of both war and terrorist events.
We have identified a growing number of EVA companies that we expect to own, based on our valuation modeling and in-person management visits, during which we have been able to further validate our modeling analyses. When we believe the time is right, we will own many of these companies. At the moment, however, we believe our clients will continue to be rewarded by our current strategy of staying substantially in cash investments.
We continue to make an effort to speak with our clients personally as often as possible. We have several good analytical articles about the current status of the markets that we are sharing with people as we meet. If you would like to read any of these articles, or have questions for either of us, please let us know.
We wish you a Happy Christmas.
Sunday, September 01, 2002
Client Letter - 9/1/02
September 2002
To Our Investors and Friends:
Our job is to make money for our investors. That may seem obvious, but things we are seeing day-to-day in the equity markets make us wonder. Last Friday night there was a heated debate on CNBC between Jim Cramer, an experienced money manager, and a mutual fund manager from Value Line. Cramer strongly contended that his only job was to make money for his investors, even if that means being only partially invested for periods of time. The Value Line mutual fund manager contended that his clients expect him to be fully invested in the market, even if it means incurring losses. While there should be no question in anyone’s mind that we are equity investors, we also believe that the best way to make money in the equity markets right now is to conserve capital and be substantially invested in cash and T-bills. There will be a time to begin reinvesting, but not yet. Our job is to decide when and at what prices. That is how we expect to serve our investors and, quite simply, make money and outperform the S&P 500 index in the current environment.
At the risk of being too technical, we would like to briefly discuss the concept of “Market Risk Premium”(MRP), because it defines the prices one should be willing to pay for equities. Historically, MRP has amounted to a 6% annual return or “premium” for the risk investors take by owning stocks, rather than owning risk-free government securities. So, if you can get a 5% yield from a long-term government bond, you should expect to get an 11% yield from an equity investment. Simple, no? Well, maybe not, because the high prices that equities have commanded in the markets for the last several years would seem to redefine MRP as something like 3% or less. The implication of this phenomenon is that market risk is much lower today and, therefore, we should be willing to pay more for stocks and accept a lower return. All of us know that is wrongheaded, but why then do many money managers, as mentioned above, insist on remaining fully invested, thereby sustaining high market prices? The answer, of course, is that they are in error, and those who recognize the erroneous ways of the market have, over time, made significant gains at the expense of the herd.
Our modeling process is focused on the concept that we must not pay more for a stock than a market risk premium of 6% dictates (it’s built into the cost of capital we use as our discount rate). On that basis, we have identified several EVA companies that meet our criteria, but we are not yet ready to move forward because we expect a downward adjustment in the overall market. We undoubtedly will take positions in some of these companies over the next several months to take advantage of market fluctuations. However, unless overall market valuations move down to more sustainable levels, our strategy for the time being will be to capture yield and pull back for another buy/sell opportunity.
It’s worth repeating Michelangelo’s statement that “Genius is eternal patience.” We appreciate your patience.
Best regards,
To Our Investors and Friends:
Our job is to make money for our investors. That may seem obvious, but things we are seeing day-to-day in the equity markets make us wonder. Last Friday night there was a heated debate on CNBC between Jim Cramer, an experienced money manager, and a mutual fund manager from Value Line. Cramer strongly contended that his only job was to make money for his investors, even if that means being only partially invested for periods of time. The Value Line mutual fund manager contended that his clients expect him to be fully invested in the market, even if it means incurring losses. While there should be no question in anyone’s mind that we are equity investors, we also believe that the best way to make money in the equity markets right now is to conserve capital and be substantially invested in cash and T-bills. There will be a time to begin reinvesting, but not yet. Our job is to decide when and at what prices. That is how we expect to serve our investors and, quite simply, make money and outperform the S&P 500 index in the current environment.
At the risk of being too technical, we would like to briefly discuss the concept of “Market Risk Premium”(MRP), because it defines the prices one should be willing to pay for equities. Historically, MRP has amounted to a 6% annual return or “premium” for the risk investors take by owning stocks, rather than owning risk-free government securities. So, if you can get a 5% yield from a long-term government bond, you should expect to get an 11% yield from an equity investment. Simple, no? Well, maybe not, because the high prices that equities have commanded in the markets for the last several years would seem to redefine MRP as something like 3% or less. The implication of this phenomenon is that market risk is much lower today and, therefore, we should be willing to pay more for stocks and accept a lower return. All of us know that is wrongheaded, but why then do many money managers, as mentioned above, insist on remaining fully invested, thereby sustaining high market prices? The answer, of course, is that they are in error, and those who recognize the erroneous ways of the market have, over time, made significant gains at the expense of the herd.
Our modeling process is focused on the concept that we must not pay more for a stock than a market risk premium of 6% dictates (it’s built into the cost of capital we use as our discount rate). On that basis, we have identified several EVA companies that meet our criteria, but we are not yet ready to move forward because we expect a downward adjustment in the overall market. We undoubtedly will take positions in some of these companies over the next several months to take advantage of market fluctuations. However, unless overall market valuations move down to more sustainable levels, our strategy for the time being will be to capture yield and pull back for another buy/sell opportunity.
It’s worth repeating Michelangelo’s statement that “Genius is eternal patience.” We appreciate your patience.
Best regards,
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