To Our Clients and Friends of Parthenon Capital Management
The S&P 500 fell 13.2% in the first six months of the year. But the first half was only a prelude to the weakness to follow. Since the end of the quarter, the market decline has accelerated with the index now down more than 20% for the year. The decline, which began in March 2000, is now over 40% at this writing – the worst bear market since 1973-74 and, at 28 months, the longest since World War II. Did the collective intrinsic value of American business also plunge 40% over that time? No, but the value had not risen over 200%, as the stock market did, in the five years preceding the peak. In our opinion business conditions do not appear as dire as the dramatic decline would indicate, just as the prospects were never as certain and open-ended as the preceding market rise seemed to signal. Stock prices will ultimately reflect their underlying business values, but the circuitous path they follow on the journey is, and always will be, inherently unpredictable. We attempt to achieve a margin of safety against permanent capital loss by paying significantly less than our estimate of intrinsic value for high quality businesses. As long-term investors, we accept that there is no protection against short-term losses in a rapid and indiscriminate market drop. Even though we warned and worried about the excesses we saw at the market top, we could not and did not predict the timing of the downturn or the shape of the unfolding correction. Neither can we predict the ultimate market “bottom” or the short-term impact on our stocks. But we can predict that the long-term opportunities are becoming increasingly compelling.
The “certainty premium” that stocks enjoyed over two years ago is now becoming an “uncertainty discount.” The market decline for the first two years was reasonably discriminating. The selling was primarily concentrated in the most extremely overpriced stocks and troubled businesses. The selling has now accelerated and become much more indiscriminate. It is this indiscriminate selling that will produce compelling opportunities. Each bear market has its own unique stories, causes, heroes, and villains. But at least one thing is eternal – the more unpleasant the recent experience with stock ownership has been, the more ownership one should establish. When shopping for stocks we much prefer to purchase goods marked down with an “uncertainty discount.”
Skepticism and Security Analysis
Valuation extremes and earnings disappointments precipitated the end of the bull market. Much of the decline of late has been exacerbated by multiple revelations of accounting fraud and corporate deception. These revelations have created an atmosphere of distrust and doubt about the accuracy of all corporate reporting and the honesty of those doing the reporting. In addition, the auditing “watch dogs” appear to have been well fed and asleep on the front porch. The most egregious incidents have occurred at troubled businesses with deteriorating business models. But some of the most well known and respected firms have taken advantage of the flexibility of our accounting system to burnish and smooth results. We have read that one of the consequences of the market collapse is the return of skepticism to the Wall Street investment community. Perhaps, but we have always felt that a healthy dose of skepticism was an integral part of the investment process and our skepticism has spared us on many occasions. We feel that most corporate executives are honest. But the extraordinary market rise helped fuel powerful incentives to “game” the system to meet analysts’ expectations and support ever rising stock prices. The increase in compensation (options and bonuses) plans tied to relatively short-term stock price movements has been the most prominent reason for executives, in some instances, to deliver the results the market expected by any means necessary. Also, we have rarely encountered a CEO, or any other top corporate official, who felt that his stock was overvalued and that the prospects for his business were less robust than the current market consensus (at least one who would admit it publicly). The indictments of prominent corporate officials and the destruction of a major accounting firm are almost certain to promote more transparent reporting of business results and less “creative” accounting. But the need for some incredulity will remain.
The Price/Quality Trade-Off
Our conservative posture over the past several years and our reluctance to initiate many significant new positions for the past 12-18 months has not been due to a prescient market call. Rather, our disciplined approach has always been to pay only a compelling price for high-quality businesses. The problem we have faced has been, to phrase it simply and succinctly, that “what is good is not cheap and what is cheap is not good.” It is not enough for us to find a cheap stock if the business does not have the competitive advantages we desire or to identify a great business if the stock price already reflects the business quality. A significant drop in a stock price is always enticing to us, but most of the declines are usually justified responses to new adverse business developments and revelations. The drop may be dramatic but the price is usually not compelling. When setting our price and quality “filters” we run the risk of being too tight or too loose. Over the years we have found that our filters are more likely to be too tight rather than too loose. One consequence is that we have, to our later regret, passed on some good opportunities. But the benefit of committing only a few painful mistakes has more than compensated. It is a trade-off with which we are comfortable.
Although our expectations remain moderate, the risk/reward ratio for stocks we own and are studying is the most attractive since the mid-90s. We are increasingly confident that returns will approach historical levels for equities. We are also more confident that we can create a portfolio of stocks that will track the growth in business value over the long-term. However, we do not feel that stock values are broadly low, so we would not expect a significant valuation expansion over and above the growth in business values. The economic and geo-political issues that precipitated the collapse remain. But stocks in some instances have priced in the uncertainty.
We appreciate the confidence you have shown us. We will continue to work diligently to preserve the assets you have entrusted to our care and carefully venture into the growing opportunities a weak market provides.
