To Our Clients and Friends of Parthenon LLC
In spite of turbulent economic news and geopolitical events, the equity and bond markets were subdued in the first half of the year. The major stock market indices made little headway for the period, and volatility was mild by recent standards. The S&P 500 rose 3.44%, while the Dow Jones Industrials rose only 0.80%. Bond yields increased slightly in response to stronger economic news and higher inflation statistics. The ten-year Treasury bond yield rose to 4.58% from 4.25%. The economic acceleration prompted the Federal Reserve to raise the Federal Funds rate 0.25% to 1.25%. The Federal Reserve had reduced rates dramatically beginning in January 2001 from 6.50% to a low of 1.00% by June 2003. The markets already anticipate more increases over the next year, and we agree with that forecast. A Federal funds rate of 1.25% is not permanently compatible with an economy growing 3% to 5%. For now, both short and long rates remain near historical lows. For some perspective, the ten-year Treasury yield was 7.32% a decade ago, and 13.81% a decade prior to that. The extended decline in rates has enhanced equity valuation levels significantly over the past twenty years. A moderate increase in rates may dampen valuations, but should not be a major negative for stocks. A more significant and sustained increase would prove more problematic but we do not, at this time, see compelling evidence to support that eventual outcome. Equity investors should not necessarily fear a moderate rise in rates, if rates are driven higher by strong economic growth accompanied by only a minor increase in the rate of core inflation. An alternative of continued historically low rates brought about by a renewed downturn in growth, and hence, weaker corporate profits, is not a particularly desirable scenario for stocks.
We entered this year with modest expectations for long-term equity returns. We continue to believe that is the most realistic outlook, and recommend planning for overall market returns of around 6% to 8% annually. Our equity outlook, as always, is valuation based, with a time horizon of at least five years.
Something From Nothing.
The lackluster stock market has encouraged many pundits to speculate on what it may signal. Does the market’s lack of direction signal a prelude to another bull market jump, or the lull before the next bear market decline? We do not spend much intellectual energy on that question, nor do we despair over the market’s minimal movement over an extended period. Market slumber is not necessarily bad. This is a situation where “nothing” can create something. An extended period with little market movement, coupled with solid underlying corporate earnings growth, can be a recipe for value creation. We have often been attracted to, and enjoyed success with, businesses whose stocks have traded flat for several years, but whose underlying business values have grown. A 15% increase in business value, combined with a flat stock price, can create the same “price cut” as an instantaneous 15% stock drop. Profiting from this “price cut” takes patience and discipline. We will continue to work hard to practice both.
The Little Picture.
The always-high obsolescence rate for anxiety inducing economic statistics seems to be growing. In only twelve months, investors’ primary economic concern seems to have come full circle, rotating initially from a fear of deflation in a weak economy to concerns of runaway inflation in a robust economy. Now the most recent batch of economic data, which indicates some slowing in the economy this summer, has precipitated yet a third shift in sentiment back to the fear of slowing growth, and weaker profits, once again. What role does the “big picture” play in our equity investment decisions? We have covered the subject of “macro” factors and their limited influence on our equity investing previously, but it is worth revisiting. The news and statistics that flow unabated concerning inflation, job creation, terrorism and security, politics and overall economic growth can be deafening at times. We do not doubt that all those variables can have an impact on stock valuations at any discrete point in the future. We do not dismiss those variables as irrelevant to future valuations. But their inherent and extreme unpredictability over our long-term investment horizons renders them of little use to us in business valuation. It is difficult to rely on predicting the unpredictable as a cornerstone of value creation. It is assumed by many that they must have a strong opinion on the future course of these “macro” factors, and act accordingly. We have never purchased a stock, nor deferred the purchase, because of these issues. Instead, we study the “little picture” – individual business intrinsic values – for the long-term. However, while we do not rely on long-range macro forecasts, we do believe it is important to understand current conditions and the impact of current economic conditions on margins, profitability, and volume growth for any business we own or study. This provides a context to delineate sustainable and enduring earning power from the cyclical elements. Finally, we have observed one constant through all the vicissitudes experienced over many years of investing: the businesses that deliver the profits we expect when we analyze them and estimate their values ultimately deliver the returns we desire.
The overall level of the market indices is not always a reliable barometer of the number of underlying attractive investment opportunities. Just as it is possible to drown in a pond with an average depth of only two feet, the inequalities below the market’s surface are more important than the overall averages. Several astute investors have recently raised serious concerns about stock valuations. We believe the overall valuations in our universe, while not as attractive as two years ago, are also not nearly as unattractive as the late 1990s. But, we do observe a “leveling” of valuations, with fewer obvious areas of manifest relative under-valuation. This homogeneity provides fewer compelling bargains and may account for some of the discontent. We share that frustration somewhat, but we recognize it is not a permanent condition. Neither is it necessarily an indicator, in our opinion, of an impending serious market downturn, although negative exogenous events always have the potential to drive the market lower in the near-term. We will search wherever good businesses can be found. Our flexibility and willingness to hunt for values among different industries and business sizes has always been advantageous and may prove more so in this environment. We will remain flexible in our search for values while remaining inflexible on price.