To Our Clients and Friends of Parthenon Capital Management
The S&P 500 rose 2.3% in the first quarter while the 30-year Treasury bond yield fell from 6.48% to 5.84% although shorter rates increased on average by .25% to .50%. That concludes our summation of the first quarter. We suspect the market’s activity in the first two weeks of April is of much greater interest and import so we will depart from our usual practice of ending our comments with the end of the calendar quarter. Over the first two weeks of the second quarter the S&P 500 fell 9.4%, dragged down primarily by the previously high-flying and seemingly invulnerable Technology and Internet stocks. The recently ubiquitous Nasdaq index, comprised primarily of such stocks, fell an astonishing 25.3% in the second week of April alone and at the bottom had fallen 34.2% from its closing high on March 10. These brief statistics tell only part of the story. Many of the most speculative and hyped Internet stocks have dropped 50% to 90% from their highs. We will not attempt to dissect and explain the timing of the dramatic turnaround in sentiment. We did not forecast or understand the extraordinary valuations given to many of these stocks.
Our habit is not to try to predict the inherently unpredictable but to respond to these events opportunistically. In our year-end letter we noted the two characteristics this current speculative fever may share with previous ones – the disregard, even disdain, for historic valuation parameters and the sense of the “sure thing”. At this point it is uncertain if either attitude has been completely discredited but both are clearly under scrutiny. Equally clear is that the decline has sent an unambiguous signal to those who may have forgotten, and to those who never knew, that price does matter in investing. In a world of perfect symmetry, the sectors of the market that had become so richly valued would now fall to levels of significant under-valuation. Whether such symmetry will occur we do not know but we suspect at least isolated values will arise and we intend to be prepared.
Is the market decline simply a necessary return to more rational valuations and realistic expectations or does it portend something more ominous? Ownership of individual stocks and mutual funds is widespread today and should the market, not only the more manic areas but also the overall market, remain down or decline further, consumer spending seems certain, at the margin, to be reduced. The Federal Reserve is already trying to engineer a general slowdown in the economy with its recent, and probably future, interest rate hikes. If robust consumer spending becomes a bit more subdued because consumers feel less wealthy, the market decline might prove beneficial to that cause, reducing somewhat the need for future interest rate hikes. A moderate economic slowdown, on balance, would not be a major hurdle for most of our holdings. We currently see little systemic risk to the near-term earnings of our companies. In general, as a predictive tool this downturn probably offers little economic guidance at this point. Whether the decline itself becomes a cause of significant economic disruptions will depend on the duration and ultimate severity.
We know the extreme volatility in the market over the past several months has been unsettling. We have had our share of uncomfortable moments. By nearly all statistical measures there have been few periods with greater stock market turbulence. It is difficult to watch a stock rise or fall 10% to 20% or more in a week or less and not think the move must reflect a corresponding change in underlying intrinsic value. In some instances it does as a company’s outlook is revealed to be better (or worse) than generally believed. But actual long-term intrinsic business values change very little week to week. The moves more often reflect changes in sentiment and market psychology as one industry moves into favor and another to disfavor – at least for that week. Such price movements, though more extreme lately, are actually consistent with historical price patterns for most stocks. It is difficult to remain focused on underlying values. They are not quoted in the paper or discussed every minute on financial news shows nor provide much daily excitement. But those values are the ultimate determinate of wealth. While volatility should be viewed as the friend of the long-term investor we are aware it can be a difficult friend to embrace.
Value or Growth?
Our insistence on the importance of price to our investment decisions may give the impression that earnings growth is a secondary and far less important factor in our search. Actually, we are quite removed from hard-core “value” investing. In theory, any business if bought cheaply enough should offer a satisfactory investment return. Warren Buffet described buying cheap assets as the “cigar butt” approach. Finding a still lit cigar with one puff may not provide the most pleasurable smoke but that last puff comes at a bargain price. This is not a style with which we are comfortable or particularly adept. We have found that buying “cheap enough” is difficult as cheap can often become a moving target in a bad business. A mediocre business by definition has less protection from economic attack and hence greater risk of a decrease in value over time. We prefer to blend a judicious concern for both price and growth prospects. We are increasingly insisting on more defined growth prospects with greater fortifications protecting the current earning power of our major investments. Time is on your side with a business building value. Unfortunately the market has recently priced many solid growth companies at levels that require an inordinate amount of time for the value to catch up to the current price. Our challenge is to find the rare under-appreciated gem. We will leave no stone, industry, or market sector unturned in the search.