To Our Clients and Friends of Parthenon LLC
The S&P 500 returned 10.87%, and the Dow Jones Industrial Average a modest 5.30% (both with dividends re-invested) for the year. It would be tempting to refer to this as a “normal” year since total returns were close to the historic average for the broad equity market. However, the “normal” has been quite “abnormal” in recent history. Over the past decade there have been seven positive years for the S&P 500. The past year was the only positive year in which the S&P was up less than 20%. Over the long-term, stocks have returned approximately 9%, but that average has been, and will continue to be, composed of much wider swings for any given year. The sedate results of 2004 were not in keeping with the more dramatic swings, up and down, of the past decade. Interestingly, even after two years of strong results (the S&P 500 is up 42%), the trailing five-year cumulative return for the S&P remains negative at –10.98%. That is a succinct illustration of why we attempt, through detailed analysis and price discipline, to reduce the risk of permanent capital loss in any stock we purchase. It can take a long time to overcome significant losses in equities.
The past year may have been a subdued one for stocks but it was an active year for the Federal Reserve. The Fed raised its target short-term interest rate five times, increasing rates from a record low of 1% to 2.25%, as the economy accelerated and inflation ticked higher. Although the Fed is worried about a return of higher inflation, thus far the bond market is sanguine about inflationary prospects. The ten-year Treasury bond yield ended the year virtually unchanged at 4.22% after starting at 4.25%. We believe it is probable that rates will ultimately trend higher if the economy remains intact, and our outlook calls for very modest total returns in bonds. Our outlook for total annual equity returns is 7% to 8% for the overall market. This is essentially unchanged from our view one year ago. This stance risks becoming repetitive and boring, and clearly lacks any feelings of deep gloom or exuberance. Fortunately, we do not observe the extreme and abundant overvaluations seen five years ago that would justify a strongly negative stance. Nor do we see, unfortunately, the many compelling valuations we found in the early- to mid-90s. The broad market is priced at approximately 17 times expected consensus 2005 earnings, modestly above long-term averages, if valuations are adjusted for below average long-term interest rates. From current stock levels, we expect little increase in valuation to be placed on earnings and, hence, we do not anticipate returns will exceed the long-term growth in business intrinsic values plus dividend yields. Combining overall earnings growth of 5% to 6% and a market dividend yield of slightly below 2%, we arrive at our return expectations. If results are to exceed this level earnings growth rates will have to outpace historical averages, or a higher valuation will have to be placed on earnings in the future. Both are possible but we think unlikely. We remain, as always, rational optimists, but advise against raising your equity outlook significantly due to any excitement or enthusiasm generated by the solid returns of the past two years.
The Past as a Template for the Future
As we have stated in previous letters, our long-term equity outlooks are valuation based. We assume an “average” long-term macro economic and geopolitical environment. One could say that we build into our forecast a little of this and a little of that. While we are acutely aware of current economic conditions on business profitability, we do not try to predict the timing of future global economic and geopolitical scenarios, nor their impact much beyond the next year. In general, we expect the future to be, in total, much like the past. The problems may be different, but we believe the impact on overall business profitability will be similar. While this has proven a rational and profitable attitude in the past, it is fair to ask if it is possibly a naïve approach today, given the seemingly intractable problems our nation and economy face. The list is long and foreboding and includes, among others one could list, terrorism, entitlement program funding shortfalls, large budget and trade deficits, and the weak dollar. While stocks are only modestly above historic averages, some say that is misleading since the problems we face are also above average in severity and in their potential to damage corporate profitability. The reason we do not allow anxiety over these issues to preclude our purchase, and continuing ownership, of good businesses at reasonable prices is quite simple – throughout our career we can recall only a few occasions when such concerns did not seem daunting. The point of significant risk for equity holders usually corresponds to those periods when the exogenous risks are deemed minimal and stock prices reflect, as they did in early 2000, a cloudless and abundant future. We do not dismiss nor belittle these concerns. We share them. Although we cannot predict the ultimate impact of any particular concern we can prepare as we always have. We do not have to be totally at the mercy of unknown exogenous events. An asset mix with the appropriate blend of growth, stability, and income, coupled with ownership of financially sound businesses, can smooth the navigation through the difficult storms that may arise.
Over the past several years, investors have seen abundant and irrefutable evidence that owning a stock entails risk. Investment risk, broadly defined, comes in two types: market risk and individual company risk. Market risk is related to the macro issues we discussed above that can precipitate and deepen a general market decline. Company risk refers to anything that threatens to diminish the earning power and intrinsic value of a specific company. Investors have recently witnessed abundant, and myriad, examples of the possible business risks, from the extreme to the commonplace. The owners of Merck woke up one morning to discover that their company was forced to pull a very profitable drug from the market, putting a serious dent in its earning power and creating significant legal liability. The owners of numerous insurance brokers felt the same unpleasant sensation when hearing the news that much of the industry’s commission structure would be dismantled after the New York Attorney General attacked certain business practices, some long accepted and legal, and others more nefarious. How should an investor react to these events? If we are already an owner, we first take a deep breath, Zen-like, and then we analyze. If we are not already an owner we can skip the deep breathing exercises and proceed directly to the analytical phase. First we have to dissect the damage, if any. The business may be worth less, but the stock has almost certainly dropped. The paramount issue is to determine the extent of the damage and the impact on long-term profitability and growth.
We have studied many companies after the “news,” both as current and prospective owners. We view these events as potential opportunities and look (hope) for the market to overestimate the severity and longevity of the impairment. The quality and financial strength of our businesses reduces the risk of major hits but does not eliminate it. Paying a price for a stock that discounts a conservative outlook provides additional protection against damage from the occasional unpleasant surprise. We will strive, as always, to minimize the risks while looking for opportunities to reap the long-term gains available through the ownership of strong, growing companies.