To Our Clients and Friends of Parthenon Capital Management
For the first time in a generation the S&P 500 fell for two consecutive years. The Index fell 11.8% in 2001, which completes the first consecutive declines since 1973-1974. The past year was also the worst year for the index since 1974. Interestingly, this was only the second time since World War II that the index had fallen two years in a row. Depending on one’s perspective (and investment portfolio), the stock market’s decline the past two years could be described as sobering, disappointing, encouraging or enlightening. We believe it should not be described as irrational. Instead, we have witnessed the return of rationality and a more logical equity “risk premium” to discount economic and general and specific business uncertainties. Because of the opportunities created this is not an altogether unwelcome revaluation for long-term investors (unless the bulk of an investor’s assets were in the most heavily “revalued” sectors.)
Government and private economic reports and statistics coming out over the past 45 days seem to indicate that the economy is stabilizing. The positive impact of lower interest rates along with rapid corporate production cutbacks and inventory reductions have slowed and perhaps halted the economic slide. Corporate earnings reports for the fourth quarter show little sign of improvement but some indication of an end to the deterioration. An improvement in the overall corporate profit environment is almost certainly necessary for a sustained improvement in the overall stock market. But it may not be enough for the broad market. Valuations for many sectors of the market are not cheap by historical standards and already appear to anticipate a fairly robust recovery, which is likely to limit the upside when earnings begin to improve later this year. Recall that the S&P 500 is a weighted index. A small minority of the companies has an outsized influence on the index’s valuation levels and results. Many companies, the large technology stocks in particular, remain very richly priced on current and estimated future earnings. This skews the overall valuation parameters and obscures the disparity in valuations. We have no opinion on the near term direction of the market and only modest expectations over the intermediate to long-term from current levels, but we believe some individual stocks are compelling and offer quite reasonable long-term prospects, particularly when evaluated in a low interest rate environment.
The close of this difficult two years for most investors would seem a good time to review our philosophical viewpoint. We were scratching our heads in stunned disbelief only two years ago at the extraordinary events in the investment arena. Our beliefs had never been so sorely tested and, for a brief period, seemingly repudiated. Events since have only reinforced our conviction in our philosophy and our faith that a disciplined application of it will deliver very satisfactory long-term results with only moderate risk. We often get inquiries from long-time, newer , and prospective clients with similar themes. Below we paraphrase and answer a few questions as a means of both addressing the inquiries while articulating our core philosophy and methodology.
What attracts you to a particular stock?
The initial “hook” for us is a business that earns an above-average return on capital over an entire economic cycle. A high return on capital is, we believe, the best indicator of a superior business. Almost invariably, a high return company has enjoyed some significant competitive advantage such as a strong business franchise, low cost production, economies of scale, or some other proprietary industry position. We spend most of our qualitative analysis time on identifying the advantage and determining if it is enduring. A business with high returns is always under competitive attack. Many, if not most, competitive advantages are ultimately diminished by a superior business model, changing societal norms, or shifting technology. A second characteristic we seek is a business that generates free cash. We make a distinction between reported earnings and cash earnings. A company that must re-invest all (or more) of its earnings simply to run in place is not attractive. We look for businesses that generate cash over and above the internal maintenance capital needs. Although we do not insist on management brilliance (and might not always be able to identify it if we did), we demand a capable, responsible management team with a history of success. We look closely at the decisions management has made as stewards of shareholder capital. Finally and perhaps most importantly, we want a modest stock price that offers superior returns if our conservative outlook is achieved and limited downside if it is not. We want to pay a price that we believe is significantly below the price a rational buyer, using cash, would pay to own the entire business.
How do you find your ideas?
You might say we rummage and root around for them. In fact, we have compiled a fairly extensive universe of businesses we would like to own through many years of study. We search for possible new additions to our stable by screening through basic financial sources and with extensive reading of the financial press. In addition, we are always on the lookout for industries that are out of favor but that may contain an unfairly tarnished gem. If the headlines are dire for an industry the odds are high that our interest has been aroused. Occasionally a business may be misunderstood or under-appreciated for no obvious reason. More often a good business is cheap because a cloudy near-term outlook obscures brighter long-term prospects. So we are on the prowl for companies that have experienced short-term “hiccups” in their progress. Finally, we wait patiently. And then wait some more for the opportunity to purchase a high quality business at a cheap price. The quality of the businesses we study and the prices we demand mean the opportunities are rare under most market conditions.
Where is the market going this year?
When asked this question we usually paw the ground, shuffle our feet and say we have no idea. But the question is serious and deserves more consideration and illumination. It is fair to ask if it is not contradictory to offer an opinion on overall valuations and expectations of long-term returns, but profess to have no opinion of the market’s likely result for this or any other single year. Our answer to that is fairly simple. A longer period will usually smooth the unpredictable psychological and momentum effects and allow valuations to predominate. The past four years is quite illustrative. After 1997 we warned, probably to the point of annoyance, that the 20% returns of the previous several years were very unlikely to be repeated. The market, as you may recall, then proceeded to rise over 20% each of the next two years. This made us look highly unqualified for the role of market soothsayers. But with the last two years included the return on the S&P 500 since the end of 1997 has been only 5.7%, a bit below but not far from our original expectations. Our market outlook is always valuation-based and long-term, in keeping with our overall investment philosophy.