To Our Clients and Friends of Parthenon Capital Management
Investors must search back over a quarter century to find a more negative year for total return on the S&P 500 Index than 2000. The Index fell 9.1% after an unprecedented string of five straight years with returns over 20%. The worst damage, obviously, occurred in the stunningly overvalued technology/internet sector but there was also significant weakness elsewhere, primarily in economically sensitive areas including retailing and basic materials. A combination of unsustainable valuations in the most popular industry sectors and an economic slowdown that exceeded general expectations was the ostensible cause of the weak market.
The economy decelerated much more quickly and dramatically than most analysts and economists had expected only six months ago. Higher energy prices, consumer debt levels, and the negative wealth effect of a falling market have all contributed to the slowdown. The Federal Reserve has lowered interest rates twice for a total of 1% since the end of the year to combat the slowdown and attempt to reaccelerate the economy. The slowdown has exacted a heavy, and ongoing, toll on corporate earnings and we expect earnings to continue to be weak in many industries in the near term. It has been quite a shock to many investors to learn that so many seemingly invulnerable “new economy” companies are, after all, impacted by the forces of competition and economic cycles. The “new economy” unfortunately, but quite predictably, shares this attribute with the “old.”
The economic news emanating from the media, and our commentary above, has a decided negative cast. But we are mindful of the extraordinary strength and resilience of the U.S. economy over the past twenty years. Our economy has demonstrated the ability to absorb shocks with little lasting damage. The banking and real estate crisis of 1990 and the Asian economic collapse of 1998, though painful at the time, are now historical footnotes that did not derail, for long, the march of economic progress. Policy makers have learned some valuable lessons over the past 50 years in managing the economy. Perhaps most importantly, it is easy to exaggerate the impact of any economic/financial “hits” on an economy as diverse and large as America’s. We can not predict the extent or duration of this slowdown. But it is important to look beyond the “valley” although its depth and width are unknown. If we find values we will buy even though the short-term macro-economic outlook may be less than robust. The most compelling opportunities often arise during periods of economic stress.
The worst hit sectors of the market are certainly cheaper than they were and cheap by the standards of the past two years. But are they cheap based on more permanent and enduring standards? We are sifting through the rubble of the collapse and remain steadfast in our belief that long-term values should reflect more enduring criteria. Simply being less expensive than the “bubble” prices of a year ago is not, in our opinion, enough. Prices should provide an entry point that combines a high probability of superior returns with an acceptable level of risk. We use price as a means to reduce the risk of long-term capital loss. The risks, which derive from the inherent uncertainties of financial analysis, are reduced significantly, we believe, by adhering consistently to a strict price discipline.
Requiem for Hype and Speculation?
As extraordinary as the valuations in the Internet and technology area appeared to us at the peak with hindsight we realize they were even more outlandish than we thought. Only one year ago Internet toy retailer eToys had a valuation greater than the combined value of the two largest U.S. toy makers, while the Internet media company Yahoo!’s value exceeded that of Disney and Viacom combined. Today, shares of eToys stock are priced below one dollar and Yahoo! is valued at only one-third the value of Disney alone. Although the extent and magnitude of this “bubble” was unprecedented, there will never be a real requiem for manias. Valuation extremes on some scale in some sectors of the market will occur with unpredictable frequency and duration. As we had indicated in past letters, although we had a strong conviction that this particular mania could not endure, we had an equally strong conviction that predicting the timing and extent of its demise was beyond our abilities. Irrational valuations can last a lot longer than a rational investor’s patience. It is always helpful, and probably wise, to remember that just because something happens in the stock market does not make it right. However, we did recently read one hopeful sign that the feverish daily interest in the stock market may be subsiding – the ratings for most TV financial news shows have fallen appreciably since the market decline began.
The importance of thinking long-term was never more clearly illustrated to us than over the past 15 months. Many stocks we owned or purchased in the fall of 1999 had, within six months, fallen into disfavor as investors increasingly migrated to the “hot” sectors of the market. Move forward only nine more months and a complete reversal has occurred with a near stampede back to many of the previously shunned sectors. Although the extreme shifts of the past 15 months are unlikely to be duplicated, we expect, for numerous structural reasons, that the market volatility and sentiment swings that temporarily favor one sector over others will continue at levels above the long-term norms.
Afflicted by a slight bout of immodest self-promotion, we have included, for those who might have missed it, a copy of a newspaper article discussing our first year. Although we were misidentified as a brokerage firm instead of an asset management firm, the article did capture some of our philosophical leanings. What did not survive the author’s editing however, was our discussion of our clients’ confidence and loyalty as the most important factors in our successful start during such turbulent times. For that, we are extremely grateful.