To Our Clients and Friends of Parthenon Capital Management
Stocks finished the third quarter down marginally as measured by the S&P 500 Index. The Index, with dividends included, was down .97% in the quarter and down 1.37% through the first three quarters. The market has continued to weaken slightly in the fourth quarter with the S&P 500 now down 2.36%. The “mood” swings among traders and investors have been even more pronounced than usual this year. Here is an interesting fact: although the very narrow Nasdaq market is down nearly 20%, 8 of the top 10 largest percentage gains ever have also occurred this year. The manic-depressive tendencies of the market have rarely been more evident.
Bond yields fell amid more tangible signs of an economic slowdown. The 10-year Treasury bond yield fell to 5.80% from 6.44% at the end of 1999. The slowdown has been orchestrated by the Federal Reserve. The cycle was supposed to go like this: The Fed raises rates and the economy slows, so inflation remains subdued, and interest rates drop. The “virtuous” cycle continues and stocks keep rising. Unfortunately, there was one final phase to the cycle – corporate earnings growth slows. The market weakness reflects the adjustment to more moderate overall earnings expectations. The “adjustment” has been swift and brutal in the most speculative and expensive sectors.
Expansion to Contraction?
Beginning in 1982, and continuing until this spring with only minor and relatively brief interruptions, the market price relative to the underlying value of publicly traded companies has expanded dramatically. The U.S. stock market has reached all-time record levels as measured by almost any ratio including price to earnings, price to cash flow, and total market value to U.S. gross domestic product. The value expansion was driven by several factors – lower inflation and interest rates, stronger economic and corporate profit growth, and improved industrial competitiveness and efficiency. Layered on top of the fundamentals has been the steadily more positive psychology and attitude of investors toward stocks. The more the market rises the more investors believe it must and will rise.
Does the market weakness of the past year mark the end of this expansion or another temporary interruption in an inexorable climb? Is it the beginning of a contraction? These are “tricky” questions for us to contemplate because we neither make market predictions nor rely on them for investment decisions. We address them not with an intent to discern the market’s near-term or intermediate-term direction. Rather, we feel it is important to appreciate the impact the valuation expansion had on total returns and the implications if, as seems likely, it is over. The S&P 500 price-to-earnings ratio expanded from approximately 7 to 25 over 18 years. That revaluation of every dollar of corporate earnings added 7.3% annually to the total return on the index. That was a wonderful tailwind for the journey, contributing well over 30% of the total annualized return.
A valuation contraction, if it occurs, could take any of several forms including moderate returns that track below corporate earnings growth or perhaps an extended period with no overall market progress. We have no particular insight into the likely path. But, with slower earnings growth, little or no additional push likely from significantly lower interest rates, and little probability that the overwhelmingly positive sentiment toward stocks will improve, a return to lower valuation levels over the next five to ten years seems probable. This does not imply that equity returns must be negative over the next decade. In fact, if the overall market remains both turbulent and weak we expect to find numerous good long-term investments over the next several years. But total returns, we believe, will more closely track value growth. The implications are important for planning purposes and asset allocation decisions. An interesting implication, we think, is that the opportunity cost (the gap between cash returns and the market averages) of holding cash while waiting for the “fat pitch” will be much lower. For the patient long-term investor, less ebullient markets can be a long-term positive.
Caution and Opportunity
“Three-fourths of the mistakes a man makes are made because he does not really know the things he thinks he knows” James Bryce, British historian and statesman.
Even with stock indices near all-time highs on most valuation metrics, there are many companies with profitable histories that appear inexpensive by these same metrics. Perhaps more than we have observed in at least five years. And yet, we hesitate to buy. Our concern is that the market is correct in many instances to price in lower levels of future profitability, even assuming reasonably good economic conditions. We think many of these “cheap” companies have structural problems that will reduce future returns on capital including manufacturing and retail capacity issues, balance of power shifts between suppliers, vendors, and distributors, and technological changes. Many recently reported earnings, and company-forecasted future earnings, for businesses have fallen stunningly below prevailing consensus estimates. This is, in part, a reflection of the slowdown in the economy but also, we believe, indicates long-term profitability impairment. We “know” a company is selling at 10 times estimated earnings-unless earnings turn out to be only 1/2 those estimates, in which case the stock was at 20 times earnings, and not nearly the bargain it appeared to be. We intend to remain very interested but extremely wary of alluringly cheap stocks. The “siren’s song” of a low price is enticing but the “rocks” of declining secular profitability are dangerous.
Finally we have wondered, as Internet stock valuations implode, if numerous company founders (and venture capitalists) may have proceeds from stock sales made at much higher prices that exceed the total current market value of the businesses they founded and funded. This is not an implicit indictment of recent entrepreneurs or venture capitalists (we joined this esteemed group ourselves last year). They have collectively added enormously to America’s current and future prosperity. Rather, it is an explicit warning to beware of the hype that is created by Wall Street, sometimes aided and abetted by company insiders, about the certain and glorious prospects for so many new, and often money-losing, ventures.