What We Expect in 2014

After the huge market recovery we saw in 2013, it seems unlikely that we will see a repeat performance in 2014.  What seems more probable is that we will see corrections and rallies around current market levels and, given the expected continued recovery of the U.S. economy from six years of recessionary and deflationary conditions, at least some positive overall movement in the markets.  In other words, the equity markets will probably be up in 2014, in response to improving economic conditions and corporate profits, but not nearly as much as they were last year.  By the same token, we would expect the bond markets to be down, as long-term interest rates begin to rise, in response to the Federal Reserve’s gradual pull-back of its historical quantitative easing posture.

The Federal Reserve had a very big impact on both the U.S. economy and the equity and bond markets in 2013.  The magnitude of the Fed’s actions over the past five years is quite remarkable.  When the financial crisis hit in 2008, the Fed’s balance sheet stood at a fairly normal level of about $800 billion.  It is now five times as large at nearly $4 trillion.  This is the result of successive rounds of “quantitative easing” (QE), in which the Fed has bought U.S. Treasury bonds and mortgage backed securities, which has had the effect of both monetizing the federal deficit and flooding the country with newly created dollars .  In its latest QE round, which began in September 2012, the Fed has bought $85 billion in bonds per month, an annualized rate of over $1 trillion.  Just now they have started to “taper” this program with the potential of ending it before year-end.  Where did all this money go?  While it’s impossible to say exactly, some of it went into the housing market to fund mortgages, but a very large portion of it has certainly found its way into the equity markets, thus driving up stocks.

It is remarkable that this vast creation of money has not caused inflation (i.e. too much money chasing too few goods).  This would indicate that, without the Fed’s ultra-liberal posturing, the economy might well have fallen into a deflationary spiral in the last couple of years, which would have had a very negative effect on the world economy and equity markets.

The trick, then, will be for the Fed to begin pulling back on quantitative easing in 2014 without negatively affecting the U.S. economy and equity markets.  There will be a lot of anticipation, which is likely to result in some degree of market correction, as we go through the year.

It is our intention to stay invested throughout the coming months and look for opportunities to deploy additional capital.  Here is what we said a year ago in “The Case for Stocks in 2013”, which bears repeating as we begin this new year:

“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.”

The key word above is “undervalued”.  While we have all enjoyed the run-up in equity prices of the last year, it is hard to find  good companies, i.e., those without “issues”, that are not at least fully valued in this market.  It’s been quite a few years since we have seen this kind of situation, but history teaches that corrections are always in the wings in this scenario.  So the question is not if a correction will come, it is what will cause it and when.  Given the huge reliance of the economy and equity markets on the Fed’s QE strategy, as important as it has been, it seems likely that the Fed’s exit strategy and how it is executed by the new Fed chair, Janet Yellen, could be the likely source of concerns in the market over the next 12 months.  The other imponderable, of course is the geopolitical situation, terrorism etc., which is always on our radar screen.

So, we will watch, wait and analyze.  We have quite a few names we would like to own, in addition to our current portfolio so, when the time comes to deploy additional capital, we are ready. 

Happy New Year!

Jack and Peter Falker

January 10, 2014

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.

Ditto!

Happy New Year,

Jack and Peter Falker

January 4, 2013

Market and Strategy Update

As all of our clients know well, we have been very conservative in our market allocations since the financial crisis began in 2008, choosing the path of protecting capital and focusing on dividend income. That served us well over the last several years, allowing us to avoid much of the extreme market volatility. But we have always considered that position to be temporary. Our longer-term objective is to find value opportunities across the entire market, without a bias toward any particular industry or economic sector.  Given the current dynamics of the markets and global economy, we are making this transition gradually.

The second quarter was the polar opposite of the first quarter from both a market and economic perspective.  The best performing economic sectors in the first quarter became the worst performers in the second.   The European situation flared up again and the U.S. economy has been stagnant.  We are starting to see the impact on earnings expectations from the European troubles.  As a result of slowing growth around the world, particularly in China, oil prices have eased significantly, relieving some concerns about rising input costs and inflation. 

In relative terms, the U.S. economy has emerged as the winner.  Banks are far more resilient from a capital adequacy perspective and the housing market has stabilized.  This has removed concerns of possible systemic banking failure such as we faced in 2008-09.  Besides the effect of recession in Europe, uncertainties over our future government policy and leadership likely pose the most significant risk to the economy today.  Perhaps not so much the policy itself, but the uncertainty of what those policies will be.  With the so-called “fiscal cliff” looming and the elections in November, we will start to see more clarity on policy direction.

In response to slower growth, central banks are further pursuing easy monetary policy and leaders in Europe are again taking steps to fight their debt crisis.  Importantly, because of so many disappointments from such policy makers in the recent past, we think investors are increasingly more skeptical.  Such skepticism can be an important ingredient for a healthier investment environment.  The markets have been routinely buoyed by persistent hope and optimism.  That one-sided mentality has made it difficult for value investors to frame longer-term return expectations. 

In light of that development, we have continued to gradually diversify the equity portfolio, as we discussed in this blog in April.  With these steps to be more fully invested, however, comes greater market risk and we have not been immune from the decline in the market during the second quarter, most notably in several financial, materials and consumer discretionary stocks. However, we continue to be heavily weighted in the consumer staples sector (almost double the market weighting), where dividends are higher and earnings have been strong.  That continues to benefit us, as the sector is currently trading at its highest level since 1995.  So, as we have become more diversified, our equity performance in the second quarter was quite similar to the overall market. 

We plan to own about 40 companies in economically diverse sectors for the equity portfolio.  Our primary focus remains on companies that are generating good Returns on Capital and EVA, while trading at relatively attractive valuations.  We are not market timing or expecting short-term trading profits.  Not all of our investments will meet our expectations, so we are always considering necessary adjustments.  At any given time we are evaluating the prospects of roughly 120 companies that meet our basic criteria.  Historical analysis shows that a disciplined strategy of owning value-creating companies at relatively low valuations, outperforms the market over time.  As we move away from our very conservative sector allocation of the past two years and become more fully invested, we would expect our portfolios to reflect similar out-performance patterns.

Thanks for your continued trust.  Please let us know if you have questions.

The Falkers

Market and Strategy Update

Stock Market Slogan...Print, Baby, Print

First, let’s explain some of what is behind the recent market rally. Perhaps the most important factor in the stock market’s rise this year has to do with recent actions by the European Central Bank (ECB). In December, amidst a brewing economic and banking crisis, the ECB offered European banks the opportunity to borrow unlimited amounts of money for 3 years at an interest rate of 1%. The reason for this Long Term Refinancing Operation (LTRO) was clear. Fears of insolvency, resulting from concentrated investments in potentially bad debt from certain European countries, had closed access to the credit markets for many European banks. Where no money could be found, the ECB turned on the printing press.

What the ECB did is important. In both Europe and the United States, central banks continue to fill the void in credit markets as the world economy recoils from a massive debt bubble. Perhaps in the short-term, by taking financial collapse off the table, we are better off. Even though the US stock market had zero return last year, the Federal Reserve’s launch of QE 2 in August of 2010 provided a powerful rally from that point until May of 2011. That rally was very similar in cause, magnitude, and character to the current rally.

Clearly central banks are buying time for policy makers to adapt and economies to adjust. Yet, it is necessary to remain aware of how much support is provided by their actions. The Federal Reserve has injected more than $2.5 Trillion into U.S. Treasuries and Mortgage Backed Securities since 2008. With LTRO alone, the ECB provided almost $700 Billion to support European banks.

As a result, the equity markets, which were starting to price in financial meltdown in Europe, are now pricing in a more optimistic view. Expectations have quickly turned positive with bullish sentiment of stock market forecasters approaching historically high levels. We have seen a significant rally in “low-quality”, beaten-down stocks, as they recover from last year’s lows. While those stocks have led the market, there has been a broad advance in US equity indexes, supported in part by decent economic data in the US.

With expectations for support from global central banks every time a problem appears, it seems likely that markets could hold up reasonably well this year. However, we would like nothing more than for the economy and market to move away from a dependence on easy money. While central banks have made it clear they will continue pursuing easy monetary policy, perhaps the only thing to get in their way will be politics. With the U.S. election straight ahead, their job could become more complicated. While the Obama administration might benefit from the Fed’s proactive policy supporting the stock market this year, Romney has already indicated that he is not in favor of reappointing Fed Chairman Ben Bernanke.

Taken in full context, we understand and appreciate the market rise this year. As always, it is good to consider both sides of the coin. Apparently Goldman Sachs does. Goldman’s Chief Global Equity Strategist recently issued a research piece (close to the recent market high) saying that now is the best time to own stocks in a generation. At the same time their Chief US Equity Strategist has a year-end target for the market about 11% below where it currently trades. Let’s just say cognitive dissonance has become a common psychological condition for any investor these days.

The Apple Effect

We would be remiss if we didn’t address one of the more remarkable impacts on the market: Apple.

Consider that the Dow Jones Industrial Average of 30 stocks was up about 7.5% to end the first quarter, while the S&P 500 was up nearly 12%. Also by comparison, FalkerInvestments’ equities were up about 7.5% year-to-date. Now consider that neither the DJIA nor FalkerInvestments hold Apple stock, while it is the largest component of the S&P 500. Looking at the table below, you can see that one stock, Apple, accounted for 15% of the total return of the S&P 500 Index in the first quarter! (click chart to make it bigger)

I don’t know the history, but this sounds like some kind of record. Anyway, the obvious question is: why don’t we own Apple? The simple answer is that it just doesn’t fit into our model. Clearly from an EVA perspective, it is one of the best value creators the world has ever seen in such a short period of time (their long-term history isn’t so great). However, from a valuation perspective it’s just too expensive. That may sound ridiculous with the stock up 54% in just 3 months (was it cheap 3 months ago?). But then also consider what the market underestimated then, it might be overestimating now. While not thought to be overvalued by most investors who own the stock, much of Apple’s value depends on keeping up a relatively torrid growth rate for such a large company. Who are we to doubt that Apple can continue with its recently stellar track record? (We love our i-Phones too). At the moment, Apple fits somewhere between a growth stock and value stock. Even though what they have been able to accomplish seems obvious now, it has been a speculative stock the whole time. While it’s unlikely Apple will fit our value model anytime soon, we keep a close eye on how it performs, because it just might dictate the next move in the market.

Strategy Update

Here’s an update on what we’re doing. As we said in our year-end blog post, after twelve months of zero return in the stock market, investors had generally become risk-averse and pessimistic. Entering this year we were making plans to start broadening out the portfolio, becoming more economically diversified and less defensive. As our clients are well aware, given the tumultuous and somewhat unprecedented economic events that have unfolded globally since 2008, we had chosen the path of protecting capital and focusing on dividend income. That served us well last year, providing positive returns and avoiding much of the extreme market volatility. But we have always considered that position to be temporary. Our longer-term objective is to find value opportunities across the entire market, without a bias toward any particular industry or economic sector.

We have started to execute that plan, but have adjusted our timing somewhat with the market surge. We have increased our overall market exposure (i.e. reduced our cash position) by only a few percentage points, mainly focusing on becoming more diversified. By means of explanation, consider our investments in Consumer Staples and Utilities, two of the best performing sectors in the market last year (Utilities were the best performing sector). In percentage terms, our client portfolios were roughly 20% and 14% invested in Consumer Staples and Utilities, respectively. That compares to their weights in the S&P 500 of roughly 11% and 3.5%. Much of that overweight position was afforded by our underweight positions in Financials and Industrials, two of the worst performing sectors last year, Financials being the worst. Again, with Europe’s banking system looking vulnerable to a very severe economic crisis, we avoided the chance that insolvency “over there” could impact the financial system here.

So, as one might expect with the current rally, the first quarter has seen a complete reversal of fortune for those sectors, with Utilities the worst performer and Financials one of the best (as you can see from the chart above). Therefore, our transition, while well planned, has slowed somewhat as we are, in simple terms, reluctant to “buy higher and sell lower”. However, we have made significant progress finding what we consider to be compelling values in sectors where we have been underweight. Given the strength in the market, a few of those stocks have already exceeded our expectations. While not a topic for this blog, we will relay our thoughts on new holdings during client meetings and occasional blog updates.

We will continue trimming back our exposure to the Utilities and Consumer Staples sectors as we seek value opportunities in other sectors. How much we continue to reduce our absolute cash position will be somewhat dependent on market corrections. As we gradually transition the portfolio, our goal is to own around 40 stocks that together represent all 10 economic sectors of the market. At any given time we are considering roughly 120 companies that meet our basic criteria of generating EVA while trading at relatively low valuations. Historical analysis clearly proves that a disciplined strategy of owning value-creating companies at relatively low valuations outperforms the market.

Thanks for reading. Let us know if you have any questions.

Peter and Jack

April 9, 2012

From 2011 into 2012

FalkerInvestments’ investment strategy performed well in 2011, with equity returns of 7%, on average, as compared to flat price performance of the S&P 500 index. Our overall portfolios, which hold a mix of equities and bonds and were over-weighted toward cash during the year (depending on the risk tolerance of each client), also outperformed the S&P 500 benchmark. We are pleased with this performance given the high level of portfolio insurance afforded by our cash position during a turbulent year.

Europe’s sovereign debt problems dominated market psychology for most of 2011. The United States experienced a weak economic recovery, which was enough to at least partially offset concerns about Europe, and resulted in the S&P 500 Index ending the year almost exactly where it began, the first time that had happened in 64 years.

As we enter 2012, we will likely see a continued slow economic recovery in the United States. This is the result of several factors, including tight credit conditions in the private sector, limited fiscal stimulus due to growing levels of U.S. Government debt, and continued uncertainty about future government policy (e.g., financial regulation, taxes). At least one certainty has been the unprecedented support from the Federal Reserve. Given current conditions, the Fed has committed to a zero interest rate policy into 2013.

Unless some extraneous geopolitical or “black swan” event intervenes, it seems probable that the U.S. equity markets could increase moderately in 2012, treating Europe’s deepening recession only in terms of how it affects U.S. corporate earnings. Because U.S. financial institutions are intertwined in Europe’s affairs, they are the ones most likely to be affected, while multi-national industrial companies will fall back on their U.S. and non-European businesses.

We expect to capitalize on the good performance of our EVA-based equity strategy in 2012 by deploying a greater proportion of our client capital toward dividend-paying, value-creating equities, for those clients whose risk tolerance calls for equity investments. We think the valuation of the market, after zero appreciation in the past 12 months, now has a fair amount of risk-aversion embedded in it. This may well provide for a better-performing equity market in 2012 and, accordingly, we began this week to deploy at least some of our cash position toward high-quality stocks.

As always, we will be watchful of world economic and geo-political conditions, as well as being very selective about what we do. We are, however, encouraged by broader acceptance of these challenging conditions by investors and policy makers alike. Two years ago in this blog we spoke about an expected transition in the markets from excessive risk-taking to one of risk-aversion. That transition is underway and beginning to provide opportunity.

Thanks for your continued trust.

Jack and Peter Falker

January 6, 2012