To Our Clients and Friends of Parthenon LLC
The S&P 500 finished the first half of the year with a modest total return, including dividends, of 2.71%. The overall results give an impression of placidity, but belie the turbulence the equity markets have experienced since spring. The relative calm of the first quarter gave way to significant volatility in the second. During the second quarter, the S&P suffered its first quarterly loss since the first quarter of 2005, dropping 1.44%. Indexes composed of small – and mid-size companies declined even more as investors realized anew that risk is a four-letter word. Amid concerns over potential inflation risks, the Federal Reserve continued to raise short-term interest rates. The Federal Reserve raised the Funds rate to 5.25% at the end of June, the seventeenth increase since beginning the rate hikes nearly two years ago. Short-term rates have become more competitive with probable equity returns, and the opportunity cost of holding cash while waiting for compelling stock prices has decreased dramatically. Long-term rates, which until recently had not followed short rates higher, finally began to move upward as the ten-year Treasury bond yield moved from 4.39% at year end to 5.14%. The recent jump in rates not withstanding, long bond rates still remain historically low, and appear to price in only a modest risk of a significant rise in inflation. The low long-term bond rates indicate some confidence by the market in the Fed’s inflation fighting abilities and/or the belief that an impending economic slowdown will decrease any building inflationary pressures.
A shortage of suitable subjects for investors to worry about is a rare occurrence. The usual suspects are dominating the headlines now including inflation, recession, terror, war, and others. Although we spend little of our equity analytical energy and time attempting to divine the ultimate outcome of these variables, we are mindful of the current, and potential, impact general economic and geopolitical events exert on earnings prospects. But, while mindful, we are not deterred. If the investment goal is long-term growth, we feel, as Winston Churchill said, “You will never get to the end of the journey if you stop to toss a stone at every dog that barks.” In trying to achieve long-term growth, we will not defer the purchase of an attractive stock in a strong business in the probably vain hope of waiting for a period with less uncertainty that offers equally compelling prices. For long-term investors, opportunity accompanies uncertainty. Our expectations for stock returns have changed little since the beginning of the year. We believe returns from current prices should at least follow the growth in business values for the broad market. We continue to search for stocks we believe will deliver a “two for one,” through increased earnings and an increased valuation placed on those higher earnings by the market.
Too Much Chasing Too Little
The most popular investment sectors, not surprisingly, took the worst hit in the second quarter. Emerging markets, most commodities, and small stock indices, all recent targets for “hot” money, suffered declines, some sizable. Although history is replete with examples that it is often ill advised, money always flows disproportionately to the sectors that have been popular – the continuing triumph of hope over experience.
An eminent economist has described general price inflation as “too much money chasing too few goods.” That may also be an appropriate description for some of the “investment inflation” seen recently. Consider the relative size of some of the world’s public equity markets. The U.S. stock markets in total, at the end June, were approximately 37% of the total worldwide public market valuation. By comparison, India was an estimated 1.3%, China 1%, Brazil 1.3% and Russia 1.8%. Of course, the relative size of the economies is not captured by these statistics since much of the emerging nations’ gross domestic product is either state or privately owned. Even a modest change in investment targets by the stewards of the enormous investment funds of the developed world can have a dramatic impact on the emerging markets. The combination of a lot of money piling into small markets is a pleasure when the funds move in but, unfortunately, the leverage can work in both directions, as many investors discovered in the second quarter.
We are neither direct investors nor students of the commodity markets and have no plans to remedy that deficiency. We plan to make no bold (or meek) predictions about the future price trend for any particular commodity. But, we have thought the shapes of the price charts for nearly all publicly traded commodities over the past year were quite interesting. They nearly all look identical and, prior to the recent declines, virtually all had climbed straight up. It seems curious and highly unlikely that the industrial production and supply and demand characteristics for all commodities would be in such perfect synchronization. The synchronization, we suspect, was in the speculative investment demand.
Big, Strong, and Attractive
We have commented in our recent letters that we believe many larger companies, which in the aggregate have under-performed smaller ones over the past several years, were becoming relatively, and absolutely, attractive. We are always wary of making such sweeping sector generalizations, and would add the obvious caveat that not all cheap stocks are large company stocks, and not all large company stocks are cheap. But, we have experienced a multi-year period during which many high quality, large company growth stocks have under-performed, in some cases dramatically, the growth in the underlying business values. An illustration can be seen in the history of General Electric (GE) and Microsoft, chosen not at random, but rather because they were the two companies with the largest public market values at the beginning of the decade. At that time, GE stock was priced at $51.58 per share and Microsoft was $58.38. GE stock finished this past quarter at $32.96, while Microsoft closed trading at $23.30. Earnings for both took a different trajectory during this period, with GE earnings climbing from $1.07 per share in 1999 to $1.83 for the past twelve months and Microsoft earnings grew from $.70 to an estimated $1.25. The price to earnings contraction has been stunning, with GE falling from 48 times earnings to 18, and Microsoft from 83 to 19. In addition, we would argue that earnings for both companies are “cleaner” now because they include a charge for employee options expense. A valuation well below the exorbitant levels of the late 90s only means that a stock is cheaper, but does not guarantee that it is a value. But, we believe an increasing number of large, financially strong companies are priced to deliver solid long-term investment returns. The market currently places a greater value on earnings that come in smaller packages. In addition, although most companies receive an earnings lift from a strong economic recovery, smaller companies generally benefit more than large growth companies. Many smaller companies have enjoyed recent earnings growth rates that have been enhanced by favorable economic conditions, and they may receive less tailwind going forward in a moderating economy. We are multi-capitalization investors and have no preference for where we find our opportunities. But earnings are earnings and, most importantly, cash is cash regardless of the relative size of the enterprise producing it. We prefer to buy the cheaper, if temporarily less popular, enterprises.