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!
Saturday, September 11, 2004
Client Letter - 9/11/04
September 11, 2004
To Our Investors and Friends:
Three years after 9/11, despite all that has happened since that day, the socioeconomic tone of our country is best described as uncertain; uncertain about terrorism, uncertain about politics and the election, about the war in Iraq, about the price of oil, about the dollar and, mostly, uncertain about the economic well-being of our country and world.
Since socioeconomic attitudes are what drive the stock market, it too is very uncertain. In the three years since 9/11, the S&P 500 Index has risen just two percentage points. In other words, the Index’s highly touted 26 percent gain in 2003 just barely offset its losses in 2002 and its virtually flat performance thus far in 2004. Since the market had declined significantly in the months prior to 9/11, a more realistic measure is to look at market performance since the beginning of 2001. Viewed that way, the S&P Index has lost approximately 15 percent, a deficit that requires a 17.6 percent gain to offset. In other words, a money market cash investment with a very low yield during that whole period has significantly outperformed an investment in the S&P 500 Index! These unsatisfactory results have occurred despite a significant recovery in corporate profits during the last two years, created by massive monetary and fiscal stimuli.
It’s the economy! In our view, despite terrorist threats, election year rhetoric and the war, what mostly underlies market uncertainty are macroeconomic issues. Here is a non-political description of the situation by Stephen Roach, chief economist of Morgan Stanley, dated September 3rd:
“Forget about politics -- at least for the moment -- and consider the facts: This economic recovery, by most conventional measures, has been amazingly lousy. Annualized growth in real GDP has averaged 3.4% over the first ten quarters of this upturn, far below the 5% norm of the previous six business cycles. Nonfarm payroll employment is up only 0.1%, on average, over the past ten quarters -- hugely deficient when compared with the 2.7% record of the past six recoveries. Real wage and salary disbursements -- the essence of the economy’s organic, or internal, income-generating capacity -- is up at only a 0.8% average annual rate over the past ten quarters versus the 3.9% norm of the previous six upturns. The federal government budget is out of control, having swung from surplus to deficit by six percentage points of GDP from 2000 to 2003. This was key in pushing the net national saving rate down to its all time low of 0.4% of GNP in early 2003. Lacking in domestic saving, the US has had to import foreign saving in order to keep the economy growing; that has given rise to a record current account deficit of 5.1% of GDP. All this speaks of a vulnerable and exceedingly low-quality recovery in the US.”
Considering these facts, but also keeping in mind continued growth in corporate profits, we are carefully proceeding to deploy client capital into the market. Since 2002, when we conserved a significant amount of capital in the market downturn, we have been carefully selecting conservative, value-creating (EVA) equities that we have identified as fairly valued through our intrinsic-value modeling discipline. Many of these stocks have better dividend yields than equivalent money market cash investments and, in our opinion, all provide much better opportunities than the market in general. Our present strategy is to be approximately 70 percent invested in equities, with the balance in money market cash, between now and the election. We took some profits during the summer to protect capital and will not hesitate to do so again. However, we also will not hesitate to deploy additional capital if we see the right opportunity.
We believe that our capital-conserving and carefully analyzed equity strategies have significantly benefited our investors during the challenging times of the past three years, and should continue to do so in the uncertain times ahead. As always, we will be pleased to hear from you.
To Our Investors and Friends:
Three years after 9/11, despite all that has happened since that day, the socioeconomic tone of our country is best described as uncertain; uncertain about terrorism, uncertain about politics and the election, about the war in Iraq, about the price of oil, about the dollar and, mostly, uncertain about the economic well-being of our country and world.
Since socioeconomic attitudes are what drive the stock market, it too is very uncertain. In the three years since 9/11, the S&P 500 Index has risen just two percentage points. In other words, the Index’s highly touted 26 percent gain in 2003 just barely offset its losses in 2002 and its virtually flat performance thus far in 2004. Since the market had declined significantly in the months prior to 9/11, a more realistic measure is to look at market performance since the beginning of 2001. Viewed that way, the S&P Index has lost approximately 15 percent, a deficit that requires a 17.6 percent gain to offset. In other words, a money market cash investment with a very low yield during that whole period has significantly outperformed an investment in the S&P 500 Index! These unsatisfactory results have occurred despite a significant recovery in corporate profits during the last two years, created by massive monetary and fiscal stimuli.
It’s the economy! In our view, despite terrorist threats, election year rhetoric and the war, what mostly underlies market uncertainty are macroeconomic issues. Here is a non-political description of the situation by Stephen Roach, chief economist of Morgan Stanley, dated September 3rd:
“Forget about politics -- at least for the moment -- and consider the facts: This economic recovery, by most conventional measures, has been amazingly lousy. Annualized growth in real GDP has averaged 3.4% over the first ten quarters of this upturn, far below the 5% norm of the previous six business cycles. Nonfarm payroll employment is up only 0.1%, on average, over the past ten quarters -- hugely deficient when compared with the 2.7% record of the past six recoveries. Real wage and salary disbursements -- the essence of the economy’s organic, or internal, income-generating capacity -- is up at only a 0.8% average annual rate over the past ten quarters versus the 3.9% norm of the previous six upturns. The federal government budget is out of control, having swung from surplus to deficit by six percentage points of GDP from 2000 to 2003. This was key in pushing the net national saving rate down to its all time low of 0.4% of GNP in early 2003. Lacking in domestic saving, the US has had to import foreign saving in order to keep the economy growing; that has given rise to a record current account deficit of 5.1% of GDP. All this speaks of a vulnerable and exceedingly low-quality recovery in the US.”
Considering these facts, but also keeping in mind continued growth in corporate profits, we are carefully proceeding to deploy client capital into the market. Since 2002, when we conserved a significant amount of capital in the market downturn, we have been carefully selecting conservative, value-creating (EVA) equities that we have identified as fairly valued through our intrinsic-value modeling discipline. Many of these stocks have better dividend yields than equivalent money market cash investments and, in our opinion, all provide much better opportunities than the market in general. Our present strategy is to be approximately 70 percent invested in equities, with the balance in money market cash, between now and the election. We took some profits during the summer to protect capital and will not hesitate to do so again. However, we also will not hesitate to deploy additional capital if we see the right opportunity.
We believe that our capital-conserving and carefully analyzed equity strategies have significantly benefited our investors during the challenging times of the past three years, and should continue to do so in the uncertain times ahead. As always, we will be pleased to hear from you.
Thursday, April 08, 2004
Client Letter - 4/8/04
April 8, 2004
To Our Investors and Friends:
While still seven months from the presidential election, we are being bombarded by extreme political and economic rhetoric. One side says that because of tax cuts, unusually low interest rates and a weak dollar the economy is growing and that more jobs will eventually be created. The other side says that huge fiscal and trade deficits currently being created will eventually impact us, that jobs are being shipped offshore faster than ever, and that the deficits combined with the weakening dollar will result in substantially higher interest rates that could throw us back into recession.
Who is right? Well, judging by the performance of the stock market in the first three months of the year, both sides are right; it just depends on your time frame. As measured by the S&P 500 Index, the market is up about 2% year-to-date, and despite all the rhetoric about last year’s gains, the market has still not offset the losses it sustained in 2002. In other words, short-term positives are being offset by long-term negatives.
From a strictly economic perspective, it seems to us that corporate earnings, employment and capital spending should continue to increase in the short term, which should result in stronger stock prices between now and the election. On the other hand, regardless of who wins the election, they will have to deal with the macro-economic realities, which indicate that the path we are currently on may not be sustainable in the long term. From a strictly non-partisan point of view, the current administration, if re-elected, may have a better political opportunity to deal with the longer term economic issues, since they would have four relatively rhetoric-free years to bite the economic bullet. However, regardless of who administers it, the economic medicine is potentially quite bitter.
While all of this may sound complex, we truly wish the situation were so simple. Unfortunately, layered on top of this are all of the geopolitical realities we face as a country today. What will happen in Iraq and the Middle East? When will we be hit by another terrorist attack that our leaders seem to be telling us is inevitable? Doesn’t the attack in Spain just before their election tell us that something like that is likely to happen here? These are wild cards vis-à-vis the markets that are totally non-quantifiable.
So what is a conservative investment manager with a strong belief in the ultimate strength of this country to do? First, we believe we must take advantage of good economic conditions when they are occurring and, second, we believe we must continue to be very careful. In mid-2003, we began reinvesting the capital we had so carefully conserved in 2002. Currently we are about 70% invested in stocks, which, together with invested cash, has allowed us to moderately outperform the market this year. As always, we are focused on value-creating companies that are selling at reasonable valuations. We are also trying to own a number of companies that pay dividends, which will provide a consistent “bond-like” return, despite what might happen in the short term. Our largest holding is GE, followed by names like Johnson & Johnson, United Healthcare, General Mills, ConAgra, Berkshire Hathaway, J.P. Morgan Chase, TCF Financial, Dell, Medtronic, Wal-Mart, The Gap, TJX Companies and ATK Systems.
Because of the terrorism wild card, we expect to continue holding a percentage of invested cash, which will vary depending on our perception of the situation between now and the election. It is also our intention to take some of our profits as the year goes on to guarantee returns and generally conserve capital. After the election, we should have a better idea of what is likely to happen in the longer term.
As always, we welcome your thoughts and questions.
To Our Investors and Friends:
While still seven months from the presidential election, we are being bombarded by extreme political and economic rhetoric. One side says that because of tax cuts, unusually low interest rates and a weak dollar the economy is growing and that more jobs will eventually be created. The other side says that huge fiscal and trade deficits currently being created will eventually impact us, that jobs are being shipped offshore faster than ever, and that the deficits combined with the weakening dollar will result in substantially higher interest rates that could throw us back into recession.
Who is right? Well, judging by the performance of the stock market in the first three months of the year, both sides are right; it just depends on your time frame. As measured by the S&P 500 Index, the market is up about 2% year-to-date, and despite all the rhetoric about last year’s gains, the market has still not offset the losses it sustained in 2002. In other words, short-term positives are being offset by long-term negatives.
From a strictly economic perspective, it seems to us that corporate earnings, employment and capital spending should continue to increase in the short term, which should result in stronger stock prices between now and the election. On the other hand, regardless of who wins the election, they will have to deal with the macro-economic realities, which indicate that the path we are currently on may not be sustainable in the long term. From a strictly non-partisan point of view, the current administration, if re-elected, may have a better political opportunity to deal with the longer term economic issues, since they would have four relatively rhetoric-free years to bite the economic bullet. However, regardless of who administers it, the economic medicine is potentially quite bitter.
While all of this may sound complex, we truly wish the situation were so simple. Unfortunately, layered on top of this are all of the geopolitical realities we face as a country today. What will happen in Iraq and the Middle East? When will we be hit by another terrorist attack that our leaders seem to be telling us is inevitable? Doesn’t the attack in Spain just before their election tell us that something like that is likely to happen here? These are wild cards vis-à-vis the markets that are totally non-quantifiable.
So what is a conservative investment manager with a strong belief in the ultimate strength of this country to do? First, we believe we must take advantage of good economic conditions when they are occurring and, second, we believe we must continue to be very careful. In mid-2003, we began reinvesting the capital we had so carefully conserved in 2002. Currently we are about 70% invested in stocks, which, together with invested cash, has allowed us to moderately outperform the market this year. As always, we are focused on value-creating companies that are selling at reasonable valuations. We are also trying to own a number of companies that pay dividends, which will provide a consistent “bond-like” return, despite what might happen in the short term. Our largest holding is GE, followed by names like Johnson & Johnson, United Healthcare, General Mills, ConAgra, Berkshire Hathaway, J.P. Morgan Chase, TCF Financial, Dell, Medtronic, Wal-Mart, The Gap, TJX Companies and ATK Systems.
Because of the terrorism wild card, we expect to continue holding a percentage of invested cash, which will vary depending on our perception of the situation between now and the election. It is also our intention to take some of our profits as the year goes on to guarantee returns and generally conserve capital. After the election, we should have a better idea of what is likely to happen in the longer term.
As always, we welcome your thoughts and questions.
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