To Our Clients and Friends of Parthenon Capital Management
Although we can offer few words that would be adequate for the human toll of the terrorist attacks on America, our sympathies go out to all those who have suffered a loss. Before the attacks the economy appeared to be entering or bordering on a recession. A recession now appears inevitable. The attacks precipitated a severe, and unprecedented, economic dislocation with significant drops in consumer spending and overall business activity over the initial two weeks. In response, the Federal Reserve lowered interest rates twice, by a total of 1%, to cushion the blow. The rates directly controlled by the Fed are now at their lowest levels in 40 years. Low mortgage rates have spurred near record re-financing levels and energy costs have dropped. In addition, an array of Federal government fiscal stimulus is in place or on the way. Many indicators of economic activity have improved and some have returned to near prior levels but most are not robust. The stock market initially sold off over 10% but has now recovered to nearly the pre-attack levels. Fortunately perhaps, the 18-month market decline had already deflated much of the speculative “bubble” and the market had discounted an earnings recession of some depth. In response to the weakening economy, deteriorating earnings outlook, and terrorist attack, the S&P 500 declined 14.7% in the third quarter. The index fell 20.4% for the first nine months. A fairly deep earnings recession is underway. We cannot predict with a high degree of accuracy its eventual depth or length but the array of stimulating forces in place lead us to believe that the odds favor that the economy will return to growth by at least mid-2002. By the time a recession is obvious and painful the seeds of future growth have often already been planted.
As our nation faces a test of will and resolve, investors confront an environment that, while unique geo-politically, is not without historical investment precedent. The country has faced many periods of crisis before and emerged stronger economically. We remain, as always, cautious and conservative in our outlook but ultimately optimistic and opportunistic. Investing in the future success of a business is by its nature an activity of optimism and belief. A bet on democratic capitalism in general, and the United States in particular, has been a winning bet for over two centuries and we are quite confident that will be no less true in the years to come. Nevertheless, we think it would be unwise to simply trot out the usual historical suspects and declare, as many Wall Street pundits and Market analysts are doing, that there is a crisis so therefore this must be a compelling opportunity. In our opinion, the ratio of price to value of individual securities remains the determinant of opportunity. The market as a whole has changed little in valuation since September 10. There has been some immediate altering of valuation among stocks expected to benefit from the new national priorities and economic shifts such as defense stocks, and those expected to lose such as travel related companies and other businesses dependent on discretionary consumer spending. Among the stocks hardest hit there may indeed be opportunities. It will be necessary to distinguish between those companies that may have suffered a significant and possibly permanent business profitability impairment and those in which the near-term outlook may have become more negative but the long-term prospects remain promising. Our preferred universe of possible investments has been, and will continue to be, businesses with the competitive position and financial strength to navigate through most economic storms with only minor damage, and usually emerge in an even stronger position.
While it would be imprudent to dismiss the near-term economic and earnings impact of the attack and the deepening recession, we believe it would be equally unwise to overestimate the probable long-term impact. An important question for long-term investors is whether the intrinsic value of
American industry will be significantly lower 5 to 10 years out than it would otherwise have been. Some costs are likely to rise for many businesses, including increased security measures and higher insurance premiums, which will hinder productivity and profitability. In addition, some productivity may be reduced by changes in business operations such as the desire for
“inventory insurance,” i.e., keeping additional inventory in the event of transportation or supply disruptions. We believe the impact will be moderate but not insignificant. It will also be distributed unevenly across industries and companies. We will respond by adjusting our expectations and estimates where appropriate and, concurrently, our buy prices when necessary.
The market decline has created, we believe, quite a few reasonably valued stocks. However, we are not particularly interested in initiating positions at reasonable prices. We would prefer, for obvious reasons, unreasonably cheap prices. We have several definitions of “reasonable.” We would define reasonable as likely to provide 8%-10% returns annually over the long-term if our assumptions prove correct (a more flexible and relative definition would encompass a return 6%-8% above the inflation rate). An 8%-10% return for an entire portfolio may prove to be a quite acceptable return over the next decade but we want to build our portfolios with individual securities purchased at prices expected to deliver greater returns if our estimates and expectations are met. In this way we have built in redundancies for uncertainty and probabilities. Another way to define reasonable is a stock price that is less than a 20%-25% discount to our estimate of intrinsic value. As the discount becomes greater than 25% and the stock price becomes more “unreasonable,” we become more interested. Fortunately, in some areas the market is becoming somewhat less reasonable and more enticing.
Finally, there is nothing like shutting the barn door after the horses have trotted out. You can hear and read a great deal today in the financial press about the virtues of long- and short-term bonds and cash equivalents relative to stocks. A long-term investor should not let recent results, and perceived near-term expectations, dictate an appropriate asset allocation. Each has its own virtues, and for specific needs, are usually poor substitutes for one another. Income needs, near-term cash reserve requirements, and long-term capital appreciation are usually best served by discrete asset classes. It is important also to not confuse cash reserves held for security and probable near term spending needs with cash built up in response to the too high stock prices of the now departed bull market. An investor should be more, not less, interested in investing equity reserves today than at the height of the bull market, when the refrain was “cash is trash.” We know we are.