To Our Clients and Friends of Parthenon LLC
After three years of painful declines for the average equity investor, it was again pleasurable to own stocks in 2003. The S&P 500 rose 28.7%, including dividends. This was the strongest advance for the broad index since 1997. The gains were fueled by an economic acceleration, which contributed to a strong corporate earnings rebound, continued low inflation and interest rates, and generally positive events in the war in Iraq. For the year, the bond market experienced dramatic movement, but finished with only moderate change in long-term yields. The ten-year Treasury bond yield fell significantly in the first half of the year, to the lowest levels in over 40 years, then jumped rapidly in mid-year as economic news turned brighter. For the year the ten-year yield rose from 3.82% to 4.25%.
We consider the recitation of the past year’s market results to be a compulsory preamble to our letters. But we believe the immediate past results provide little valuable insight regarding the future direction of the markets. Weak markets can follow strong periods and strong markets often follow weak ones. The near-term path is uncertain. But what is certain to follow a strong year is increased investor optimism and exuberance. We enjoyed the year, and are also generally positive on current economic conditions. However, we suggest wariness when pundits shout that conditions are “ideal” for above-average stock returns. The market has long since discounted economic and geopolitical conditions that are readily apparent to all. We remain as agnostic as ever on short-term return expectations. Our asset allocation and stock purchase volume is driven, as always, by our assessment of specific company valuations. By those criteria, while we remain positive about our holdings, our enthusiasm for stocks in general is moderately lower than last year when we wrote this letter. Are we encountering the incipient signs of another speculative excess in the stock market, and a return to the conditions that preceded the bear market? Some things seem familiar. For example, the stocks of unprofitable companies on the New York Stock Exchange outperformed the stocks of profitable ones in 2003. While we see some pockets of significant overvaluation and speculation, our universe of stocks, though not cheap, finished the year at reasonable levels.
Climbing Out of the Hole
Investment horizons only correspond neatly to the calendar by coincidence. Few investors begin and end their investment timeframes with the beginning and end of a year or a decade. But there is an innate human tendency to think of results in neat periods. We thought it might be interesting, and perhaps revealing, to consider how the current decade may be viewed looking backward. The results point out succinctly why we work very hard to limit our risk, and how difficult it can be to recover from significant losses. We will use the S&P 500 to illustrate (all numbers for the index include dividends). The decade began with cumulative losses from 2000 through 2002 of 37.6%. After the very strong stock market of 2003, total losses for the decade still stand at 19.7%. We will assume that for the remaining six years of this decade the index compounds at 10% per year (modestly above the long-term average – not a prediction, but not unreasonable). An investor, garnering results equal to the index, will have gained a very healthy 12.5% annual return over the final seven years of the decade (2003-2009.) But, because of the losses incurred in the first three years, the total return for the entire ten years would be only 3.6%. Even in a low inflation environment, that is not the road to significant wealth creation. It can take a long time to climb out of a deep investment abyss.
MAD – Mutual Assured Destruction
The business scandals continued over the past year. They landed with a resounding thud at the doorstep of many of those who cried foul loudest when deceived by corporate leaders. The unethical, and often
illegal, practices of some mutual fund companies included several egregious practices. Some companies permitted rapid trading by privileged outside investors and hedge funds in direct violation of prospectus guidelines and company policy. Some firms allowed investors to trade at “after hours” prices (and capitalize on potential market moving news and events after the fact). The actions enriched the fund companies at the expense of long-term shareholders. The guilty companies deserve all the opprobrium that has been heaped upon them. But, none of the activities for which the companies are under fire have done as much damage to long-term investors as those investors do to themselves with the encouragement of the fund marketers. Fund companies have sliced and diced the equity market into evermore narrow and specialized pieces. There are funds for every taste and whim. You can buy a fund specific to any sector or industry, any company size, any region or nation. There are funds that bet against the market and funds that magnify returns, and losses, through leverage. Thus large fund families always have a “hot” fund to promote regardless of market conditions. Always having a hot fund means never having to say you are sorry. Unfortunately, investors swarm to the funds after the outstanding short-term performance, just in time to suffer the inevitable declines. In addition, many investors move in and out of funds in an attempt to time the market. Researchers have studied the effect of this frenetic movement and estimates of the cost vary, but all agree that the long-term results of the average stock fund investor lag well behind the stated results of the average fund. The original purpose and mission of stock mutual funds, to provide diversification and professional money management for the small investor, has long been usurped by the sales and marketing imperative at some fund companies.
This is not intended to be diatribe against fund companies in general, nor against providing wide consumer choice. Selling what the consumer wants is fundamental to capitalism and is certainly not inherently unethical. Do not expect the salesman to accentuate the caveats too boldly. Money always flows to the hot hand and the hot asset class and the phenomenon is not confined only to mutual funds. Patience, education, and a long-term perspective are the best defense against the temptation to chase the latest, and greatest, investment style and fad.
When we are asked how we “feel” about the markets or the economy, we usually pause a while before answering. Though we guard against it, we are not totally immune to the emotional swings that accompany our profession. But we try to maintain a constant investment demeanor and mindset that might aptly be called the rational optimist. We are optimistic by nature. We believe that our companies will succeed when we purchase their stocks, we believe the economic system in the U.S. is incredibly resilient and, as it has many times in the past, will overcome the seemingly daunting problems we encounter. We believe the U.S. will ultimately prevail in our geopolitical struggles. We think optimism is a necessary ingredient when staking your financial future on a collection of businesses, when that future is inherently uncertain. But our optimism is always tempered by a rational expectation of the probable returns from our current and prospective investments. That rationalism informs our analysis and our estimation of the price to pay to appropriately balance risk and reward. Our goal is to have few occasions to lament, as a line from a recent country song put it, “I know what I was feeling, but what was I thinking?” If the market continues to rally and the economic news becomes increasingly positive, we will continue to strive to keep our optimism tempered by rationality.