To Our Clients and Friends of Parthenon LLC
The market was unable to make any headway in the first half of the year. Much like the stone continuously pushed up the hill by the mythical Sisyphus, every advance was ultimately rolled back. The primary culprit was higher oil prices. Investor fears of the potential widening negative economic impact of higher oil prices, along with continued rate increases by the Federal Reserve, blunted every market advance. The S&P 500, with dividends, fell a fractional 0.81% for the first six months of 2005. The economy has, thus far, shrugged off both higher energy costs and higher short-term interest rates. The economy performed reasonably well in the first quarter with real Gross Domestic Product (GDP) growth of 3.8%, and the consensus among economists holds that the second quarter grew at a similar rate. Overall corporate profitability has also remained at high levels, although profit growth appears to be slowing from the well-above average pace of the past several years.
Even with the rally off the lows reached in early 2003, the total return on the S&P 500 for the past five and one half years is a negative 11.7%. The “great deflation” of the market bubble has occurred as the average price to earnings ratio for the broad market has shrunk to around 17, from greater than 25 at the market’s peak in 2000. As an aside, with no particular predictive value, suppose the S&P 500 compounds at 10% annually over the remainder of the decade, which is not our prediction but is not an unreasonable, if a bit optimistic, outlook. Combined with the results for the decade thus far the total return for the ten-year period would be only 35.6%, or 3.1% annualized. That would make this decade the weakest since the 1930s. If so that will be an ironic, and telling, outcome for a decade that began with stock valuations, and expectations, at extremely high levels.
Many market analysts remain convinced that stock valuations must now complete the “cycle” and, having fallen from significantly overvalued on average to reasonable, the market must ultimately decline to significantly undervalued. Those thus inclined view the rebound of the past two years as simply a brief respite in an ongoing bear market. We are aware of no reason why stocks cannot decline to levels below historical averages if the right shocks are delivered to the economy. However, we can think of no reason why they must. Although the averages are lower today, we found more undervalued stocks five years ago. The market was dramatically bifurcated then, with certain sectors and securities extremely overvalued and others significantly undervalued. Today, with stock valuations much more uniform, the opportunities are fewer in spite of an overall lower market average. Nevertheless, in our opinion the overall market valuation, based on current earnings, is neither particularly worrisome nor overly attractive. However, we are more concerned with the sustainability of current earnings levels. Corporate earnings are historically high in relation to total GDP. Whether the present ratio of profits to GDP is sustainable is problematic. Our study is increasingly focused on the durability of the profits of the businesses we own and are considering for purchase.
The most rewarding locations to have been in the equity markets over the past year are places we seldom visit. The most popular sectors of the market have been a group of long under performing sectors including basic resources, materials and commodity cyclicals. We understand and even sympathize with the recent appeal. The companies have generated strong earnings growth and the industries have very favorable near-term supply and demand characteristics. The long-term outlook also has some alluring attributes. In addition, the stocks have exhibited strong price momentum. These are all the characteristics that combine to make “hot” stock sectors. As would be expected, assets in funds devoted to natural resources have soared. We have little inclination to bet against this trend and we do not know when, or how dramatically, it will change. Our lack of substantial participation in these sectors does not indicate a judgement on the merits of the market’s current prejudices. Instead, it follows from our adherence to our long-standing philosophical principles. We have difficulty finding businesses within these groups that exhibit the history of high returns on capital, sustained and consistent earnings growth, and enduring competitive advantages we desire in our businesses. Consistent, if moderate, growth companies have long-term appeal but can look quite humdrum in comparison to businesses that are roaring ahead due to a possibly temporary confluence of favorable economic conditions. We have long accepted the reality of occasionally being temporarily out of sync with the market as a price to be paid for solid long-term results with moderate risk. We subscribe to the ancient wisdom passed on to Solomon that “this too shall pass.” We just do not know when.
A Tale of Two Interest Rates
The rates in our tale are the Federal Funds rate and the ten-year Treasury bond yield. The Federal Funds rate is a short-term rate controlled by the Federal Reserve. The ten-year bond yield is determined by the collective actions of market participants. The Fed has been raising the Funds rate over the past year to combat inflation. But to the surprise of many, and the consternation of some, the ten-year yield has actually declined slightly. This “flattening” of bond rates between short and long yields has become a sort of financial “Rorschach test” bestowed with different meanings by various interested observers. To some, it means the economy is slowing and risks falling into a recession. This could be called the historical interpretation since a flattening yield curve has, in the past, been a harbinger of weakening economic conditions. But others counter it shows that inflation is under control but the economy is not at great risk from the Fed’s handiwork. For some, it simply means that there is a tremendous amount of money floating around the world that needs a home, and the Treasury market provides a vast and secure home. One thing at least seems certain – because longer interest rates have not risen, the Fed’s move to a more restrictive rate environment is having less economic impact than the Fed, and others, probably anticipated.
We have taken the financial “Rorschach test” ourselves but have not come to any definitive conclusions. We are wary of obsessing over the meaning of any set of economic parameters. We do not want to assign overly negative or positive interpretations that may influence our investment decisions. However, the low long rates do have investment implications for us, even beyond the obvious probable lower returns from our fixed income investments. An important component of our stock valuation methodology is the long term Treasury bond yield. We use the yield to estimate the present value of future expected cash flows from the companies we analyze. A lower rate increases the present value of those future cash flows. In other words, growth becomes more valuable at lower expected interest rates. Over the past several years we have hedged our valuations modestly because of our concern that 4% long rates were not permanent. It has added a layer of protection, but at the cost of passing on some potential opportunities. If price is a factor in an investment decision, a line must be drawn in the sand somewhere. We will continue to strive for an appropriate balance between the risk of higher rates, and the reality of current rates, when assessing equity investment opportunities.